BFG 301

BANKING LAWS AND

OPERATIONS - I
SPECIAL GROUP : D - BANKING AND FINANCE GROUP

M. Com (M 17) – Part II

Semester - III

YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY

Dnyangangotri, Near Gangapur Dam, Nashik 422 222, Maharashtra
YASHWANTRAO CHAVAN MAHARASHTRA OPEN UNIVERSITY
Vice-Chancellor : Prof. E. Vayunandan
Director, School of Commerce & Management : Dr. Pandit Palande
State Level Advisory Committee
Dr. Pandit Palande Dr. Suhas Mahajan Dr. Ashutosh Raravikar
Former Vice Chancellor Former Professor & Director, EDMU,
Director, School of Commerce Research Guide Ministry of Finance
& Management, Ness Wadia College of Commerce New Delhi
Yashwantrao Chavan Maharashtra Pune
Open University, Nashik

Dr. Mahesh Kulkarni Dr. J. F. Patil Prof. V. V. Morajkar

Former Professor & Economist Former Professor
Research Guide Kolhapur B.Y.K. College,
B.Y.K. College, Nashik Nashik

Dr. A. G. Gosavi Dr. Madhuri Sunil Deshpande Dr. Parag Saraf

Professor Professor Director,
Modern College, Swami Ramanand Teerth Marathwada Institute of Management Science
Shivaji Nagar, Pune University, Nanded Pimpri, Pune

Dr. S. V. Kuvalekar Dr. Surendra Patole Dr. Latika Ajitkumar Ajbani

Associate Professor (Finance) and Assistant Professor Assistant Professor
Associate Dean (Training) School of Commerce & Management School of Commerce & Management
National Institute of Bank Management Y.C.M.O.U., Nashik Y.C.M.O.U., Nashik
Pune

Authors Editor Instructional Technology Editing &

Programme Co-ordinator
Dr. Parag Saraf Dr. Madhuri Sunil Deshpande Dr. Latika Ajitkumar Ajbani
Director, Institute of Professor, Swami Ramanand Assistant Professor
Management Science Teerth Marathwada University, School of Commerce & Management
Pimpri, Pune Nanded Y.C.M.Open University, Nashik
Dr. Latika Ajitkumar Ajbani
Assistant Professor
School of Commerce & Management
Y.C.M.Open University, Nashik

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(First edition developed under DEB development grant)
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ISBN 978-81-8055-414-8 BFG 301

 Index

Unit No. Unit Name Page No.

1 BANKING SYSTEM IN INDIA 9

2 LEGAL ASPECTS OF BANKING

OPERATIONS (CHEQUES) 22

3 LEGAL ASPECTS OF BANKING

OPERATIONS (INDEMNITIES & GUARANTEES) 38

4 LEGAL ASPECTS OF BANKING

OPERATIONS (ACCOUNTS) 51

5 TYPES OF SECURITIES IN BANKS 64

6 CHARGE OVER SECURITIES 79

7 LOANS AND ADVANCES 95

8 FINANCIAL ANALYSIS OF BANKS 114

9 RISK MANAGEMENT IN BANKS 130

10 ELECTRONIC BANKING AND IT IN BANKING 146

11 ETHICS AND CORPORATE

GOVERNANCE IN BANKING 156

12 CORPORATE GOVERNANCE IN BANKS 166

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 INTRODUCTION

I am very pleased to place this edition of the study material on 'Banking Law
& Practice' to the students and practitioners of this subject.
The syllabus and content of this subject covers most of the aspects from
gamut of banking. The objective of this subject is to give a specialized knowledge of
law and practice relating to banking.
Students are also expected to take note of all the latest developments relating
to the subjects covered in the syllabus by referring to RBI circulars, financial papers,
economic journals, latest books and publications in the subjects concerned.
I have made a sincere attempt to make the subject easy to understand. For
this purpose all the topics are written in a simple and lucid language to enable the
students to grasp the essence of subject.
This book has got knowledge oriented and exam oriented approach.
I have tried to cover all the necessary acts, laws that are necessary to
understand this subject.
Any suggestions will be appreciated.
With knowledge, hard work, marvelous success is just around the corner.
All The Best!

- Dr. Parag Prakash Saraf

Message from the Vice-Chancellor

Dear Students,

Greetings !!!

I offer cordial welcome to all of you for the Master’s degree programme of
Yashwantrao Chavan Maharashtra Open University.
As a post graduate student, you must have autonomy to learn, have information and
knowledge regarding different dimensions in the field of Commerce & Management and at
the same time intellectual development is necessary for application of knowledge wisely.
The process of learning includes appropriate thinking, understanding important points,
describing these points on the basis of experience and observation, explaining them to
others by speaking or writing about them. The science of Education today accepts the
principle that it is possible to achieve excellence and knowledge in this regard.
The syllabus of this course has been structured in this book in such a way, to give
you autonomy to study easily without stirring from home. During, the counseling sessions,
scheduled at your respective study centre, all your doubts will be clarified about the course
and you will get guidance from some experienced and expert professors. This guidance
will not only be based on lectures, but it will also include various techniques such as ques-
tion-answers, doubt clarification. We expect your active participation in the contact ses-
sions at the study centre. Our emphasis is on ‘self study’. If a student learns how to study,
he will become independent in learning throughout life. This course book has been written
with the objective of helping in self-study and giving you autonomy to learn at your conve-
nience.
During this academic year, you have to give assignments and complete the Project
work wherever required. You have to opt for specialization as per programme structure.
You will get experience and joy in personally doing above activities. This will enable you to
assess your own progress and thereby achieve a larger educational objective.
We wish that you will enjoy the courses of Yashwantrao Chavan Maharashtra Open
University, emerge successful and very soon become a knowledgeable and honorable
Master’s degree holder of this university.
Best Wishes!
Vice-Chancellor
 SYLLABUS - BANKING LAWS AND OPERATIONS - I

1) BANKING SYSTEM IN INDIA

Indian Banking System- Evolution, Reserve Bank of India (Centralized Bank), Nationalization of
Banks, State Bank of India, Regional Rural Banks, Private Sector Banks, Structure of Banks in India,
Constituents of Indian Banking System, Functions of Commercial Banks

2) LEGAL ASPECTS OF BANKING OPERATIONS (CHEQUES)

Definition of a Cheque, Different types of cheques, Crossing of a Cheque, Endorsement, Legal Aspects
of a Paying Banker, Negotiable Instruments Act and Paying Banker, Protection to Paying Banker, Legal
Aspects of Collection of a Cheque, Banker as a holder for value, Collecting Banker as an Agent, Conversion
by the Collecting Banker, Statutory Protection to Collecting Bank, Duties of the Collecting Bank

3) LEGAL ASPECTS OF BANKING OPERATIONS (Indemnities & Guarantees)

Contract of Indemnity, Application of Indemnity Contracts to Banks, Rights of an Indemnity Holder,
Time of commencement of the indemnifier's liability, Damages, Bank Guarantee, Types of Guarantee, Banker's
Duty to Honour Guarantee, Issuance of Bank Guarantee - Precautions to be taken, Payments Under Bank
Guarantee -Precautions to be taken

4) LEGAL ASPECTS OF BANKING OPERATIONS (Accounts)

Deposit Accounts and Complaints Of Customers, Savings bank account, Term Deposit Account,
Current Accounts, Complaints, Sick/old/incapacitated account holders - Operational Procedure, Customer
Confidentiality Obligations, Deceased Depositors - Settlement Of Claims - Procedure Thereof, Accounts
with survivor/nominee clause, Accounts without the survivor/nominee clause, Access to Safe Deposit Locker/
Safe Custody articles (with survivor/nominee clause), Access to Safe Deposit Locker/Safe Custody articles
(without survivor/nominee clause), Settlement of claims in respect of missing persons, Unclaimed deposits/
Inoperative Accounts in banks, General Aspects, Banking Hours/Working Hours/Operation, Declaration of
Holiday under the Negotiable Instruments Act, 1881, Miscellaneous

5) TYPES OF SECURITIES IN BANKS

Land/Real Estate as a Security for the Loan/Advance, Stocks and Shares as a Security for the Loan/
Advance, Debentures as a Security for the Loan/Advance, Goods as a Security for the Loan/Advance, Life
Policies as a Security for the Loan/Advance, Book Debts as a Security for the Loan/Advance, Fixed Deposit
as a Security for the Loan/Advance, Supply Bills as a Security for the Loan/Advance

6) CHARGE OVER SECURITIES

Charging the Security, Pledge of Security, Requirements for a Valid Pledge, Important features of
Pledge, The Rights of Pledgee are as follows, Precautions required for Pledge, Hypothecation over Securities,
Hypothecation- Meaning, Important features of hypothecation, Other important aspects of Hypothecation,
Precautions required for Hypothecation, Difference between Hypothecation and Pledge, Lien, Lien - Important
aspects, Assignment, Assignment - important features, Mortgage, Priority of Mortgages, Limitation Period in
Mortgages, Registration of Charge
7) LOANS AND ADVANCES
Principles of Lending, Credit Worthiness of Borrowers, Collection of Credit Information, Types of
Credit Facilities, Fund Based Credit Facilities, Non-Fund Based Facilities

8) FINANCIAL ANALYSIS OF BANKS

Financial Analysis, Financial Statements (Balance Sheet & P & LAccount), Advantages of analysis of
financial statements, Limitations of financial statements, Analysis of Profit & Loss A/c, Analysis of Balance
Sheet, Analysis of Cash Flow and Fund Flow Statements, Financial Analysis Techniques, Fund Flow Analysis,
Ratio Analysis, Trend Analysis, Du Pont Analysis, Special issues in financial analysis - Banking Industry,
Financial analysis by bank as lender, Banker as Investor

9) RISK MANAGEMENT IN BANKS

Risks, Features of Risk Management, Risk Management Structure, Risk Management under BASEL
I, Risk Management under BASEL II, Credit Risk Management, Liquidity and Market Risk Management,
Market Risk, Equity Price Risk, Commodity Price Risk, Cross Border Risk, Country Risk, Country Risk
Management System (CRMS), Operational Risk, Legal Risk, Risk Management under BASEL III, Reporting
of Banking Risk

10) ELECTRONIC BANKING AND IT IN BANKING

Communication networks in banking system, E-Banking, Internet, World Wide Web (WWW),
Electronic Fund Management, Electronic Clearing System (ECS), Real Time Gross Settlement (RTGS),
National Electronic Funds Transfer (NEFT), Indian Financial System Code (IFSC), Automated Teller Machines
(ATMs), Internet Banking, Core Banking Solutions (CBS), Computerization of Clearing of Cheques, Cheque
Truncation System (CTS)

11) ETHICS AND CORPORATE GOVERNANCE IN BANKING

Ethics, Rights of people, Ethical and unethical issues, Features of Ethics, Ethical Theories and Approach,
Ethics: Certain important concepts, Corporate governance ethics, Scope of Business Ethics, Ethics in
Compliance, Ethical aspects in Human Resource Management, Ethichal aspects in Marketing Management,
Ethical aspect in Financial Management, Desired Ethical Practices and Corporate Governance

12) CORPORATE GOVERNANCE IN BANKS

Classification of Banks, Regulation of Banks, Board Composition, Role of the Board of Directors,
Audit Committee (AC), Induction of More Independent Directors, Auditors and other Internal Audit Reports,
Customer Service Committee, Special Committee for monitoring large value frauds, IT Strategy Committee,
Remuneration Committee, Nomination Committee, BASEL Committee Recommendations, Auditors' Certificate
on Corporate Governance, Corporate Social responsibility in the financial Sector
 Banking System
UNIT - 1 in India
BANKING SYSTEM IN INDIA
Structure NOTES
1.0 Introduction
1.1 Objectives
1.2 Indian Banking System- Evolution
1.3 Reserve Bank of India (Centralized Bank)
1.4 Nationalization of Banks
1.5 State Bank of India
1.6 Regional Rural Banks
1.7 Private Sector Banks
1.8 Structure of Banks in India
1.9 Constituents of Indian Banking System CHECK YOUR
1.10 Functions of Commercial Banks PROGRESS
1.11 Key Concepts
1.12 Summary Describe Indian
1.13 Exercise Banking system?
1.14 Further Studies and references

1.0 Introduction
Banks are the important segment in Indian Financial System. An efficient
banking system helps the nation's economic development. Various categories of
stakeholders of the Society use the banks for their different requirements. Banks
are financial intermediaries between the depositors and the borrowers. Apart from
accepting deposits and lending money, banks in today's changed global business
environment offer many more value added services to their clients. The Reserve
Bank of India as the Central Bank of the country plays different roles like the
regulator, supervisor and facilitator of the Indian Banking System.

1.1 Objectives
After reading this unit, you should be able to:
- Understand the features of Indian Banking System
- Know the significant contribution of different types of banks
- Appreciate how important banking services for the economy

1.2 Indian Banking System- Evolution

Indian Banking System for the last two centuries has seen many
developments. An indigenous banking system was being carried out by the
businessmen called Sharoffs, Seths, Sahukars, Mahajans, Chettis, etc. since ancient
time. They performed the usual functions of lending moneys to traders and craftsmen
and sometimes placed funds at the disposal of kings for financing wars. The
indigenous bankers could not, however, develop to any considerable extent the
system of obtaining deposits from the public, which today is an important function
of a bank. Banking Laws and
Operations - I (9)
Banking Laws and Modern banking in India originated in the last decades of the 18th century.
Operations - I The first banks were The General Bank of India which started in 1786, and the
Bank of Hindustan. Thereafter, three presidency banks namely the Bank of Bengal
(this bank was originally started in the year 1806 as Bank of Calcutta and then in
NOTES the year 1809 became the Bank of Bengal) , the Bank of Bombay and the Bank of
Madras, were set up. For many years the Presidency banks acted as quasi-central
banks. The three banks merged in 1925 to form the Imperial Bank of India. Indian
merchants in Calcutta established the Union Bank in 1839, but it failed in 1848 as
a consequence of the economic crisis of 1848-49. Bank of Upper India was
established in 1863 but failed in 1913. The Allahabad Bank, established in 1865, is
the oldest survived Joint Stock bank in India. Oudh Commercial Bank, established
in 1881 in Faizabad, failed in 1958. The next was the Punjab National Bank,
established in Lahore in 1895, which is now one of the largest banks in India. The
Swadeshi movement inspired local businessmen and political figures to found banks
of and for the Indian community during 1906 to 1911. A number of banks established
then have survived to the present such as Bank of India, Corporation Bank, Indian
Bank, Bank of Baroda, Canara Bank and Central Bank of India. A major landmark
CHECK YOUR in Indian banking history took place in 1934 when a decision was taken to establish
PROGRESS 'Reserve Bank of India' which started functioning in 1935. Since then, RBI, as a
central bank of the country, has been regulating banking system.
What is RBI?
1.3 Reserve Bank of India (Centralized Bank)
The Reserve Bank, as the central bank of the country, started their
operations as a private shareholder's bank. RBI replaced the Imperial Bank of
India and started issuing the currency notes and acting as the banker to the
government. Imperial Bank of India was allowed to act as the agent of the RBI.
RBI covered all over the undivided India. In order to have close integration between
policies of the Reserve Bank and those of the Government, It was decided to
nationalize the Reserve Bank immediately after the independence of the country.
From 1st January 1949, the Reserve Bank began functioning as a State owned and
State-controlled Central Bank.
To streamline the functioning of commercial banks, the Government of
India enacted the Banking Companies Act, 1949 which was later changed as the
Banking Regulation Act 1949. RBI acts as a regulator of banks, banker to the
Government and banker's bank. It controls financial system in the country through
various measures.
The RBI plays an important part in the Development Strategy of the
Government of India.
The general superintendence and direction of the RBI is entrusted with
the 21-member Central Board of Directors: the Governor, 4 Deputy Governors, 2
Finance Ministry representatives, 10 government-nominated directors to represent
important elements from India's economy, and 4 directors to represent local boards
headquartered at Mumbai, Kolkata, Chennai and New Delhi. Each of these local
boards consists of 5 members who represent regional interests, and the interests of
co-operative and indigenous banks. Since its inception, RBI has been instrumental
in the overall development of the Indian economy institutional development. It acts
as a regulator of banks, controller of financial systems, banker to the Government
and banker's bank. RBI focuses in areas like Monetary Policy, Bank Supervision
and Regulation and monitoring developments in the financial markets.

Banking Laws and

(10) Operations - I
 Banking System
1.4 Nationalization of Banks in India

The history of nationalization of Indian banks dates back to the year 1955
when the Imperial Bank of India was nationalized and re-christened as State Bank
NOTES
of India (under the SBI Act, 1955). Later, in July1960, the subsidiaries of SBI
(Associates) were also nationalized.
On July 19, 1969 the Government of India issued an ordinance and
nationalized 14 major commercial Banks. This was considered as a major revolution
in the Indian banking system.
1. Allahabad Bank
2. Bank of Baroda
3. Bank of India
4. Bank of Maharashtra
5. Canara Bank
6. Central Bank of India
7. Dena Bank CHECK YOUR
8. Indian Bank PROGRESS
9. Indian Overseas Bank
What is nationalisation
10. Punjab National Bank
of bank?
11. Syndicate Bank
12. Union Bank of India
13. United Bank of India
14. United Commercial Bank (now known as UCO bank)
In 1980, another six more commercial banks with deposits of above ` 200
crores were nationalized :
1. Andhra Bank
2. Corporation Bank
3. New Bank of India
4. Punjab and Sind Bank
5. Oriental Bank of Commerce
6. Vijaya Bank
Later on the New Bank of India was merged with Punjab Nationalized
Bank.
The nationalization of banks resulted in rapid branch expansion which led
to many fold increase in the number of commercial bank branches in Metro, Urban,
Semi - Urban and Rural Areas. The branch network assisted banks in mobilizing
deposits and accelerated economic activities on account of priority sector lending.
The purpose of nationalization was (a) to increase the presence of banks
across the nation. (b) to provide banking services to different segments of the
Society. (c) to change the concept of class banking into mass banking, and (d) to
support priority sector lending and growth.

1.5 State Bank of India

In order to serve the economy in general and the rural sector in particular,
the All India Rural Credit Survey Committee recommended the creation of a state-
partnered and state-sponsored bank by taking over the Imperial Bank of India, and Banking Laws and
Operations - I (11)
Banking Laws and integrating with it, the former state-owned or state-associate banks. An act was
Operations - I accordingly passed in Parliament in May 1955 and the State Bank of India was
constituted on 1 July 1955. Later, the State Bank of India (Subsidiary Banks) Act
was passed in 1959, enabling the State Bank of India to take over eight former
NOTES State-associated banks as its subsidiaries (later named Associates). The State Bank
of India was thus born with a new sense of social purpose. Associate Banks of
State Bank of India viz., State Bank of Hyderabad, State Bank of Mysore, State
Bank of Bikaner and Jaipur, State Bank of Travancore, State Bank of Patiala,
State Bank of Indore, State Bank of Saurashtra have been working as per the
guidance of State Bank of India. Two banks viz. State Bank of Patiala and State
Bank of Hyderabad are fully owned by State Bank of India and in other Associate
Banks, the majority of shareholdings are with the SBI. Out of these associate
banks, two banks viz., State Bank of Indore and State Bank of Saurashtra have
been merged with the State Bank of India and merger of the remaining five banks
is under process. State Bank of India and its Associate Banks were given preferential
treatment by RBI over the other commercial banks, by appointing them as an
agent of RBI for transacting Central and State Government business as well as
CHECK YOUR setting up of currency chests for the smoother cash management in the country.
PROGRESS

What is private sector 1.6 Regional Rural Banks

bank?
In 1975, a new set of banks called the Regional Rural Banks, were setup
based on the recommendations of a working group headed by Shri Narasimham, to
serve the rural population in addition to the banking services offered by the co-
operative banks and commercial banks in rural areas. Inception of regional rural
banks (RRBs) can be seen as a unique experiment as well as experience in
improving the efficacy of rural credit delivery mechanism in India. With joint
shareholding by Central Government, the concerned State Government and the
sponsoring bank, an effort was made to integrate commercial banking within the
broad policy thrust towards social banking keeping in view the local peculiarities.
RRBs were expected to play a vital role in mobilizing the savings of the small and
marginal farmers, artisans, agricultural labourers and small entrepreneurs and
inculcate banking habit among the rural people. These institutions were also expected
to plug the gap created in extending the credit to rural areas by largely urban-
oriented commercial banks and the rural cooperatives, which have close contact
with rural areas but fall short in terms of funds.

1.7 Private Sector Banks

In 1991, the Narasimham committee recommended that banks should
increase operational efficiency, strengthen the supervisory control over banks and
the new players should be allowed to create a competitive environment. Based on
the recommendations, new private banks were allowed to start functioning.

List of the new private-sector banks in India

1. Axis Bank (earlier UTI Bank)
2. Bank of Punjab
3. Centurion Bank Ltd. (Merged Bank of Punjab in late 2005 to become
Centurion Bank of Punjab, acquired by HDFC Bank Ltd. in 2008)
4. Development Credit Bank (Converted from Co-operative Bank, now DCB
Banking Laws and
Bank Ltd.)
(12) Operations - I
5. ICICI Bank (previously ICICI and then both merged;total merger Banking System
SCICI+ICICI+ICICI Bank Ltd) in India

6. IndusInd Bank
7. Kotak Mahindra Bank
NOTES
8. Yes Bank
9. Times Bank (Merged with HDFC Bank Ltd.)
10. Global Trust Bank (India) (Merged with Oriental Bank of Commerce)
11. HDFC Bank
12. Bandhan Bank
13. IDFC Bank

1.8 Structure of Banks in India

Banks can be classified into scheduled and non- scheduled banks based
on certain factors
(a) Scheduled Banks: CHECK YOUR
Scheduled Banks in India are the banks which are listed in the Second PROGRESS
Schedule of the Reserve Bank of India Act, 1934. The scheduled banks enjoy
several privileges as compared to non- scheduled banks. Scheduled banks are What are the
entitled to receive refinance facilities from the Reserve Bank of India. They are constituents of Indian
also entitled for currency chest facilities. They are entitled to become members of
banking system?
the Clearing House. Besides commercial banks, cooperative banks may also become
scheduled banks if they fulfill the criteria stipulated by RBI.
(b) Non-scheduled banks:
These are those banks which are not included in the Second Schedule of
the Reserve Bank of India. Usually those banks which do not conform to the
norms of the Reserve Bank of India within the meaning of the RBI Act or according
to specific functions etc. or according to the judgement of the Reserve Bank, are
not capable of serving and protecting the interest of depositors are classified as
non-scheduled banks.

1.9 Constituents of Indian Banking System

(a) Commercial Banks:
(i) Public Sector Banks
(ii) Private Sector Banks
(iii) Foreign Banks
(b) Cooperative Banks:
(i) Short term agricultural institutions
(ii) Long term agricultural credit institutions
(iii) Non-agricultural credit institutions
(c) Development Banks:
(i) National Bank for Agriculture and Rural Development (NABARD)
(ii) Small Industries Development Bank of India (SIDBI)
(iii) EXIM Bank
(iv) National Housing Bank
Banking Laws and
Operations - I (13)
Banking Laws and (A) Commercial Banks
Operations - I
1. Public Sector Banks
The term 'public sector banks' by itself connotes a situation where the
major/full stake in the banks are held by the Government. Till July,1969, there were
NOTES only 8 Public Sector Banks (SBI & its 7 associate banks). When 14 commercial
banks (total 20 banks) were nationalized in 1969, 100% ownership of these banks
were held by the Government of India. Subsequently, six more private banks were
nationalized in 1980. However, with the changing in time and environment, these
banks were allowed to raise capital through IPOs and there by the share holding
pattern has changed. By default the minimum 51% shares would be kept by the
Government of India, and the management control of these nationalized banks is
only with Central Government. Since all these banks have ownership of Central
Government, they can be classified as public sector banks. Apart from the
nationalized banks, State Bank of India, and its associate banks, IDBI Bank and
Regional Rural Banks are also included in the category of Public Sector banks.
The total number of public sector banks as on March, 2014 were 83 as per the
following categorization:
(a) State Bank of India and its Associate Banks - 6
(b) Nationalised Banks - 19
(c) Regional Rural Banks - 56
(d) IDBI Bank - 1
(e) Bhartiya Mahila Bank - 1
Further, public sector banks opened 7840 branches in the year 2013-14.
2. Private Sector Banks
The major stakeholders in the private sector banks are individuals and
corporate. When banks were nationalized under two tranches (in 1969 and in 1980),
all banks were not included. Those non nationalized banks which continue operations
even today are classified as Old Generation Private Sector Banks.. like The Jammu
& Kashmir Bank Ltd, The Federal Bank, The Laxmi Vilas Bank etc. In July 1993
on account of banking sector reforms the Reserve Bank of India allowed many
new banks to start banking operations. Some of the leading banks which were
given licenses are: UTI bank (presently called Axis Bank) ICICI Bank, HDFC
Bank, Kotak Mahindra Bank, Yes Bank etc., These banks are recognized as New
Generation Private Sector Banks. Ten banks were licensed on the basis of guidelines
issued in January 1993. The guidelines were revised in January 2001 based on the
experience gained from the functioning of these banks, and fresh applications were
invited. Of the 10 licences issued in 1993, four banks merged with other lenders
over a period of time. Times Bank merged with HDFC Bank, while Global Trust
Bank was amalgamated with the state-owned Oriental Bank of Commerce.
Centurion Bank took over Bank of Punjab to become Centurion Bank of Punjab,
which merged with HDFC Bank in 2008. On account of these new generation
private sector banks, a new competitive environment was created in the Indian
Banking System. These banks were having competitive advantages over their
counterparts (of the existing old private banks, public sector banks) in their IT
support system, innovative products, and pricing of their products. Private sector
banks have been rapidly increasing their presence in the recent times and offering
a variety of newer services to the customers and posing a stiff competition to the
group of public sector banks. Total private sector banks as on 31st March 2014
were 22. Besides these, four Local Area Banks are also categorized as private
banks.

Banking Laws and

(14) Operations - I
 3. Foreign Banks Banking System
The other important segment of the commercial banking is that of foreign in India
banks. Foreign banks have their registered offices outside India, and through their
branches they operate in India. Foreign banks are allowed on reciprocal basis.
They are allowed to operate through branches or wholly owned subsidiaries. These NOTES
foreign banks are very active in Treasury (forex) and Trade Finance and Corporate
Banking activities. These banks assist their clients in raising External Commercial
Borrowings through their branches outside India or foreign correspondents. They
are active in loan syndication as well. Foreign banks have to adhere to all local
laws as well as guidelines and directives of Indian Regulators such as Reserve
Bank of India, Insurance and Regulatory Development Authority, Securities
Exchange Board of India. The foreign banks have to comply with the requirements
of the Reserve Bank of India in respect to Priority Sector lending, and Capital
Adequacy ratio and other norms. Total foreign banks as on 31st January 2014
were 43 having 314 branches. Besides these, 45 foreign banks have their
representative offices in India as on 31st January 2014*.

(B) Cooperative Banking System

Cooperative banks play an important role in the Indian Financial System,
especially at the village level. The growth of Cooperative Movement commenced
with the passing of the Act of 1904. A cooperative bank is a cooperative society
registered or deemed to have been registered under any State or Central Act. If a
cooperative bank is operating in more than one State, the Central Cooperative
Societies Act is applicable. In other cases the State laws are applicable. Apart
from various other laws like the Banking Laws (Application to Co-operative
Societies) Act, 1965 and Banking Regulation (Amendment) and Miscellaneous
Provisions Act, 2004, the provisions of the RBI Act, 1934 and the BR Act, 1949
would also be applicable for governing the banking activities. These cooperative
banks cater to the needs of agriculture, retail trade, small and medium industry and
self employed businessmen usually in urban, semi urban and rural areas. In case of
co-operative banks, the shareholders should be members of the co-operative banks.
The share linkage to borrowing is a distinctive feature of a co-operative bank.
Rural cooperative sector in India plays a vital role in fulfilling the credit requirements
of rural agricultural sector of India. At recent times, the rural credit flow through
rural cooperative sector has risen substantially in order to keep pace with the
growing demand for credit in the rural parts of India. The Cooperative rural Credit
Structure in our country are of following types:
1. Short Term Agricultural Credit institutions
The short term credit structure consists of the Primary Agricultural Credit
Societies at the base level, which are affiliated at the district level into the District
Central Cooperative bank and further into the State Cooperative Bank at the State
level. Being federal structures, the membership of the DCCB comprises all the
affiliated PACS and other functional societies and for the SCB, the members are
the affiliated DCCBs.
The DCCB being the middle tier of the Cooperative Credit Structure, is
functionally positioned to deal with the concerns of both the upper and lower tiers.
This very often puts the DCCB in a position of balancing competing concerns.
While the SCB may managing District Central Cooperative wish the DCCB to
prioritize its task in a particular manner, the PACs may have their own demands on
the DCCB. Balancing these competing concerns could often be a dilemma for the
DCCBs.
There are 30 State Cooperative Banks. These banks support and guide Banking Laws and
372 District Central Cooperative Banks (DCCBs) in India which have 13478 Operations - I (15)
Banking Laws and branches as on March, 2013. These DCCBs are providing finance to more than 35
Operations - I lakhs farmers through about 1.15 lacs Primary Agricultural Cooperative Societies
(PACS).
2. Long Term Agricultural Credit Institutions
NOTES The long term cooperative credit structure consists of the State Cooperative
Agriculture & Rural Development Banks (SCARDBs) and Primary Cooperative
Agriculture & Rural Development Banks (PCARDBs) which are affiliated to the
SCARDBs. The total No. of SCARDB's are 19; of which 10 have Federal Structure,
7 have Unitary Structure and 2 have Mixed Structure (i.e. operating through
PCARDBs as well as its own branches).Loans are given to members on the
mortgages of their land usually up to 50% of their value in some states or up to 30
times the land revenue payable in other states, duly taking into account their need
and repayment capacity. The performance of these banks as on 31st March 2012
has been as under:
No. of SCARDBs 19
No. of PCARDBs 714
No. of Branches of PCARDBs 1,056
No. of Branches of Unitary SCARDBs 761
Annual Lending 17,603.42 Cr
Total Membership 13.65 Million
3. Urban Cooperative Banks
The term Urban Cooperative Banks (UCBs), although not formally defined,
refers to the primary cooperative banks located in urban and semi-urban areas.
These banks, until 1996, were allowed to lend money only to non-agricultural
purposes. This distinction remains today. These banks have traditionally been around
communities, localities working out in essence, loans to small borrowers and
businesses. Today their scope of operation has expanded considerably. The urban
co-operative banks can spread operations to other States and such banks are called
as multi state cooperative banks. They are governed by the Banking Regulations
Act 1949 and Banking Laws (Cooperative Societies) Act, 1965. The total number
of UCBs stood at 1,618 as on 31st March 2012. Scheduled UCBs are banks included
in the Second Schedule of the RBI Act, 1934 and include banks that have paid-up
capital and reserves of not less than `5 lacs and carry out their business in the
interest of depositors to the satisfaction of the Reserve Bank.

(C) Development Banks

History of development banking in India can be traced to the establishment
of the Industrial Finance Corporation of India in 1948. Subsequently, with the passing
of State Financial Corporation Act,1951, several SFCs came into being. With the
introduction of financial sector reforms, many changes have been witnessed in the
domain of development banking. There are more than 60 Development Banking
Institutions at both Central and State level. We are discussing here below the four
major development banks which assist in extending long term lending and refinance
facilities to different sectors of economy. These financial institutions plays crucial
role in assisting different segments including the rural economic development.

1. National Bank for Agricultural and Rural Development (NABARD)

National Bank for Agriculture and Rural Development (NABARD) was
established in July 1982 by an Act of Parliament based on the recommendations of
CRAFICARD. It is the apex institution concerned with the policy, planning and
Banking Laws and
(16) Operations - I
operations in the field of agriculture and other rural economic activities. NABARD
has evolved several refinance and promotional schemes over the years and has Banking System
been making constant efforts to liberalize, broad base and refine/ rationalize the in India
schemes in response to the field level needs. The refinance provided by NABARD
has two basic objectives:
(i) Supplementing the resources of the cooperatives banks and RRBs for NOTES
meeting the credit needs of its clientele, and
(ii) Ensuring simultaneously the buildup of a sound, efficient, effective and
viable cooperative credit structure and RRBs for purveying credit.
NABARD undertakes a number of inter-related activities/services which
fall under three broad categories.
(a) Credit Dispensation:
NABARD prepares for each district annually a potential linked credit plan
which forms the basis for district credit plans. It participates in finalization of Annual
Action Plan at block, district and state levels and monitors implementation of credit
plans at above levels. It also provides guidance in evolving the credit discipline to
be followed by the credit institutions in financing production, marketing and investment
activities of rural farm and non- farm sectors.
(b) Developmental & Promotional CHECK YOUR
The developmental role of NABARD can be broadly classified as:- PROGRESS
- Nurturing and strengthening of - the Rural Financial Institutions (RFIs)
What is SIDBI?
like SCBs/SCARDBs, CCBs, RRBs etc. by various institutional strengthening
initiatives.
- Fostering the growth of the SHG Bank linkage programme and extending
essential support to SHPIs NGOs/VAs/ Development Agencies and client banks.
- Development and promotional initiatives in farm and non-farm sector.
- Extending assistance for Research and Development.
- Acting as a catalyst for Agriculture and rural development in rural areas.
(c) A Supervisory Activities
As the Apex Development Bank, NABARD shares with the Central Bank
of the country (Reserve Bank of India) some of the supervisory functions in respect
of Cooperative Banks and RRBs.

2. Small Industries Development Bank of India (SIDBI)

Small Industries Development Bank of India (SIDBI) was established in
October 1989 and commenced its operation from April 1990 with its Head Office
at Lucknow as a development bank. It is the principal and exclusive financial
institution for the promotion, financing and development of the Micro, Small and
Medium Enterprise (MSME) sector and for co-ordination of the functions of the
institutions engaged in similar activities. It is a central government undertaking.
The prime aim of SIDBI is to support MSMEs by providing them the valuable
factor of production finance. Many institutions and commercial banks supply finance,
both long-term and short-term, to small entrepreneurs. SIDBI coordinates the work
of all of them.
SIDBI has evolved a strategy to analyze the problems faced by MSMEs
and come out with tailor-made solutions. It has covered around 600 MSME clusters,
through a pan-India network of 85 branches, 50 Credit Advisory Centres, and
partnerships with cluster-level industry associations as on January 31, 2013. A
unique scheme of the credit guarantee for Micro and Small Enterprises called
CGTMSE has provided coverage to about 1 million with guarantee covers for an
aggregate loan amount of over 48,000 crore. Banking Laws and
Operations - I (17)
Banking Laws and Functions of Small Industries Development Bank of India (SIDBI):
Operations - I Over the years, the scope of promotional and developmental activities of
SIDBI has been enlarged to encompass several new activities. It performs a series
of functions in collaboration with voluntary organisations, nongovernmental
NOTES organisations, consultancy firms and multinational agencies to enhance the overall
performance of the small scale sector. The important functions of SIDBI are
discussed as follows:
(i) Initiates steps for technology adoption, technology exchange, transfer
and up gradation and modernization of existing units.
(ii) SIDBI participates in the equity type of loans on soft terms, term loan,
working capital both in rupee and foreign currencies, venture capital support, and
different forms of resource support to banks and other institutions.
(iii) SIDBI facilitates timely flow of credit for both term loans and working
capital to MSMEs in collaboration with commercial banks.
(iv) SIDBI enlarges marketing capabilities of the products of MSMEs in
both domestic and international markets.
CHECK YOUR
(v) SIDBI directly discounts and rediscounts bills with a view to encourage
PROGRESS
bills culture and helping the SSI units to realise their sale proceeds of capital goods
/ equipments and components etc.
What is NHB?
(vi) SIDBI promotes employment oriented industries especially in semi-
urban areas to create more employment opportunities so that rural-urban migration
of people can be checked.

3. National Housing Bank (NHB)

National Housing Bank was set up in July, 1988 as the apex financing
institution for the housing sector with the mandate to promote efficient, viable and
sound Housing Finance Companies (HFCs). Its functions aim at to augment the
flow of institutional credit for the housing sector and regulate HFCs. NHB mobilizes
resources and channelizes them to various schemes of housing infrastructure
development. It provides refinance for direct housing loans given by commercial
banks and non-banking financial institutions. The NHB also provides refinance to
Housing Finance Institutions for direct lending for construction/purchase of new
housing/dwelling units, public agencies for land development and shelter projects,
primary cooperative housing societies, property developers.
At present, it is a wholly owned subsidiary of Reserve Bank of India which
contributed the entire paid-up capital. RBI has proposed to transfer its entire
shareholding to Government of India to avoid conflict of ownership and regulatory
role. For this transfer, the central bank will pay RBI, in cash, an amount equal to
the face value of the subscribed capital issued by the RBI. The outstanding portfolio
of NHB at ` 33,083 crores as on 31st December 2012 is almost equally divided
between the commercial banks and the HFCs.

4. Export-Import Bank of India (Exim Bank)

Export-Import Bank of India was set up in 1982 by an Act of Parliament
for the purpose of financing, facilitating and promoting India's foreign trade. It is
the principal financial institution in the country for coordinating the working of
institutions engaged in financing exports and imports. Exim Bank is fully owned by
the Government of India and the Bank's authorized and paid up capital are ' 10,000
crore and ' 2,300 crore respectively.
Exim Bank lays special emphasis on extension of Lines of Credit (LOCs)
Banking Laws and to overseas entities, national governments, regional financial institutions and
(18) Operations - I
commercial banks. Exim Bank also extends Buyer's credit and Supplier's credit to Banking System
finance and promote country's exports. The Bank also provides financial assistance in India
to export-oriented Indian companies by way of term loans in Indian rupees or
foreign currencies for setting up new production facility, expansion/modernization
or up gradation of existing facilities and for acquisition of production equipment or NOTES
technology. Exim Bank helps Indian companies in their globalization efforts through
a wide range of products and services offered at all stages of the business cycle,
starting from import of technology and export product development to export
production, export marketing, pre-shipment and post-shipment and overseas
investment.
The Bank has introduced a new lending programme to finance research
and development activities of export oriented companies. R&D finance by Exim
Bank is in the form of term loan to the extent of 80 per cent of the R&D cost. In
order to assist in the creation and enhancement of export capabilities and international
competitiveness of Indian companies, the Bank has put in place an Export Marketing
Services (EMS) Programme. Through EMS, the Bank proactively assists companies
in identification of prospective business partners to facilitating placement of final CHECK YOUR
orders. Under EMS, the Bank also assists in identification of opportunities for PROGRESS
setting up plants or projects or for acquisition of companies overseas. The service
is provided on a success fee basis. Exim Bank supplements its financing programmes Describe functions of
with a wide range of value-added information, advisory and support services, which commercial banks?
enable exporters to evaluate international risks, exploit export opportunities and
improve competitiveness, thereby helping them in their globalisation efforts.

1.10 Functions of Commercial Banks

Sections 5 & 6 of Banking Regulation Act, 1949 contain the functions
which commercial banks can transact.
These functions can be divided into two parts:
(a) Major functions
(b) Other functions/ancillary services

(a) Major functions:

(i) Accepting Deposits
(ii) Granting Advances
(b) Other functions:
(i) Discounting of bills and cheques
(ii) Collection of bills and cheques
(iii) Remittances
(iv) Safe custody of articles
(v) Safe Deposit Lockers
(vi) Issue of Letter of Credit
(vii) Issue of Guarantees

Besides the above functions, Banks now-a-days associate themselves in

the following activities also either by opening separate departments or through
separately floated independent subsidiaries:
(i) Investment Counseling
(ii) Investment Banking Banking Laws and
Operations - I (19)
Banking Laws and (iii) Mutual Fund
Operations - I
(iv) Project Appraisal
(v) Merchant Banking Services
(vi) Taxation Advisory Services
NOTES
(vii) Executor Trustee Services
(viii) Credit Card Services
(ix) Forex Consultancy
(x) Transactions of Government Business
(xi) Securities Trading
(xii) Factoring
(xiii) Gold/Silver/Platinum Trading
(xiv) Venture Capital Financing
(xv) Bank assurance - Selling of Life and General Insurance policies as
Corporate Agent

1.11 Key Concepts

Commercial banks, Cooperative Banks and Development banks are the
constituents of Indian banking System

1.12 Summary
l A strong banking system is an indicator for the economic development of
any nation. Banks are important segment in Indian Financial System. An
efficient and vibrant banking system is the back bone of the financial sector.
The major functions of banks are to accept deposits from public and provide
lending to the needy sectors. Besides commercial banks, cooperative credit
institutions also plays important role in the rural economy of the country.
Development banks line NABARD, SIDBI, NHB and EXIM Bank are
providing refinance facilities to commercial banks and other financial
institutions.
l The Reserve Bank of India as the Central Bank of the country plays different
roles like the regulator, supervisor and facilitator of the Indian Banking System.

1.13 Exercise
Fill in the blanks
1. Banks are __________ intermediaries between the depositors and the
borrowers.
(Commercial, Financial, Social)
2. The ______________ as the Central Bank of the country plays different
roles like the regulator, supervisor and facilitator of the Indian Banking System.
(Reserve Bank of India, State Bank of India, Central Bank of india)
3. Imperial Bank of India was nationalized and re-christened as
_____________ (under the SBI Act, 1955).
Banking Laws and (Reserve Bank of India, State Bank of India, Central Bank of India)
(20) Operations - I
4. The general superintendence and direction of the RBI is entrusted with the Banking System
_______member Central Board of Directors. in India
(22, 25, 23, 21)
5. Scheduled Banks in India are the banks which are listed in the __________
Schedule of the Reserve Bank of India Act, 1934. NOTES
(First, Second, Third,)
6. NABARD, SIDBI, EXIM, NHB are categorized into _________________.
(Development banks, Commercial banks, Cooperative banks)
7. Public sector, private sector and foreign banks are examples of _________.
(Development banks, Commercial banks, Cooperative banks)
8. _________ have their registered offices outside India, and through their
branches they operate in India.
(Public sector banks, Private sector banks, Foreign banks)
9. The prime aim of _______ is to support MSMEs by providing them the
valuable factor of production finance.
(SIDBI, NABARD, EXIM)
10. _________Bank extends Buyer's credit and Supplier's credit to finance
and promote country's exports.
(SIDBI, NABARD, EXIM)

[Ans: 1) financial, 2)Reserve Bank of India, 3)State Bank of India, 4)21,

5)Second, 6) Development Banks, 7)Commercial banks, 8) Foreign Banks
9)SIDBI, 10)Exim.]

1.14 Further Studies and references

1. M.L.Tannan, revised by : Banking Law and Practice, Wadhwa & Company,
Nagpur C.R. Datta & S.K.Kataria
2. A.B. Srivastava and : Seth's Banking Law, Law Publisher's India (P) Limited
K. Elumalai
3. R.K. Gupta : BANKING Law and Practice in 3 Vols.Modern Law Publications.
4. Prof. Clifford Gomez : Banking and Finance - Theory, Law and Practice, PHI
Learning Private Limited
5. J.M. Holden : The Law and Practice of Banking, Universal Law Publishing.

Banking Laws and

Operations - I (21)
Banking Laws and
Operations - I UNIT 2
LEGAL ASPECTS OF BANKING
NOTES
OPERATIONS
1. CHEQUES
Structure
2.0 Introduction
2.1 Objectives
2.2 Definition of a Cheque
2.3 Different types of cheques
2.4 Crossing of a Cheque
2.5 Endorsement
2.6 Legal Aspects of a Paying Banker
2.6.1 Negotiable Instruments Act and Paying Banker
2.6.2 Protection to Paying Banker
2.7 Legal Aspects of Collection of a Cheque
2.8 Banker as a holder for value
2.9 Collecting Banker as an Agent
2.10 Conversion by the Collecting Banker
2.11 Statutory Protection to Collecting Bank
2.12 Duties of the Collecting Bank
2.13 Key Concepts
2.14 Summary
2.15 Exercise
2.16 Further Studies and references

2.0 Introduction
Banks maintain operating accounts like Savings Bank, Current, Overdraft
and Cash Credit accounts which are operated by the cheques drawn by the account
holders on their bankers. While handling these cheques, a banker may act as a
paying banker (when cheques are drawn on him) or collecting banker (when cheques
are deposited with him). Banks are under statutory obligation to honour a cheque
and make payment if it is in order as per relevant laws. As a collecting banker, he
should collect the cheques only for his customer and as per the provisions of the
legal frame work the Negotiable Instruments Act,1882. Legal aspects in banking
operations such as indemnities and guarantees are important in banker's point of
view.

2.1 Objectives
After reading this unit, you should be able :
Banking Laws and
- To understand the important aspects of the role of a banker as paying and
(22) Operations - I
 collecting banker Legal Aspects of Banking
- To know about the legal aspects of banking operations and the precautions Operations (CHEQUES)
taken by banks
- To understand the legal aspect of Indemnities and Guarantees
NOTES
2.2 Definition of a Cheque
A cheque is defined in Sec 6 of NI Act as under :-
(i) A cheque is a bill of exchange drawn on a specified banker
(ii) Payable on demand
(iii) Drawn on a specified banker
(iv) Electronic image of a truncated cheque is recognized under law.
The Information Technology Act, 2002 recognizes (a) digital signatures
and (b) electronic transfer as well
A cheque is nothing but a bill of exchange with special features (i) It is
always payable on demand ( A bill of exchange can be payable on demand/at sight
and/or after a specific term called as usance bill) (ii) always drawn on a specified CHECK YOUR
banker i.e., the drawee of a cheque is the banker on whom the cheque is drawn. PROGRESS
The banker with whom the customer holds his/her account. This drawee bank is
called the paying bank. The parties to a cheque are: Describe cheque?
Cheque
Drawer: Customer Payee: The beneficiary Drawee: The Bank
who draws a cheque the cheque in whose on whom the
on his account favour is payable cheque is of banker

Apart from the above three parties, others involved in payment and
collection of cheques are :
Endorser: The person who transfers his right to another person
Endorsee: The person to whom the right is transferred

2.3 Different types of cheques

(1) Open Cheque:
A cheque is classified as 'Open' when cash payment is allowed across the
counter of the bank.
(2) Bearer Cheque:
A cheque which is payable to any person who holds and presents it for
payment at the bank counter is called a 'Bearer cheque'. A bearer cheque can be
transferred by mere delivery without any endorsement.
(3) Order Cheque:
An order cheque is a cheque which is payable to a particular person. In
case of order cheque, the word 'bearer' might have been cancelled and the word
'order' is written. The payee can transfer an order cheque by endorsement to
another person by signing his name on the back of the cheque

2.4 Crossing of A Cheque

Crossing is an 'instruction' given to the paying banker to pay the amount of
the cheque through a banker only and not directly to the person presenting it at the
counter. A cheque bearing such an instruction is called a 'crossed cheque'; others Banking Laws and
Operations - I (23)
Banking Laws and without such crossing are 'open cheques' which may be encashed at the counter of
Operations - I the paying banker as well. The crossing on a cheque is intended to ensure that its
payment is made to the right payee. Section 123 to 131 of the Negotiable Instruments
Act contain provisions relating to crossing. According to Section 131-A, these
NOTES Sections are also applicable in case of drafts. Thus not only cheques but bank
drafts also may be crossed.

Cheque crossed generally

Where a cheque bears across its face an addition of the words "and
company" or any abbreviation thereof, between two parallel transverse lines, or of
two parallel transverse lines simply, either with or without the words "not negotiable",
that addition shall be deemed a crossing, and the cheque shall be deemed to be
crossed generally. [section 123]
Cheque crossed specially
Where a cheque bears across its face an addition of the name of a banker,
either with or without the words "not negotiable", that addition shall be deemed a
crossing, and the cheque shall be deemed to be crossed specially, and to be crossed
to that banker. [section 124].
Payment of cheque crossed generally or specially
Where a cheque is crossed generally, the banker on whom it is drawn shall
not pay it otherwise than to a banker. Where a cheque is crossed specially, the
banker on whom it is drawn shall not pay it otherwise than to the banker to whom
it is crossed, or his agent for collection. [section 126].
Cheque bearing "not negotiable"
A person taking a cheque crossed generally or specially, bearing in either
case the words "not negotiable", shall not have, and shall not be capable of giving,
a better title to the cheque than that which the person form whom he took it had.
[section 130]. Thus, mere writing words 'Not negotiable' does not mean that the
cheque is not transferable.
It is still transferable, but the transferee cannot get title better than what
transferor had.

"Account Payee" crossing : N.I. Act does not recognize "Account Payee"
crossing, but this is prevalent as per practice of banks in India. In view of this, RBI
has directed banks that:
(1) Crediting the proceeds of account payee cheques to parties other than that
clearly delineated in the instructions of the issuers of the cheques is
unauthorized and should not be done in any circumstances.
(2) If any bank credits the account of a constituent who is not the payee named
in the cheque without proper mandate of the drawer, it would do so at its
own risk and would be responsible for the unauthorized payment. Reserve
Bank has also warned that banks which indulge in any deviation from the
above instructions would invite severe penal action.
(3) In case of an 'account payee' cheque where a bank is a payee, the payee
bank should always ensure that there are clear instructions for disposal of
proceeds of the cheques from the drawer of the cheque. If there are no such
instructions, the cheque should be returned to the drawer.
(4) However, with a view to mitigating the difficulties faced by the members of
co-operative credit societies in collection of account payee cheques, relaxation
Banking Laws and has been extended in respect of co-operative credit societies.
(24) Operations - I
 Banks may consider collecting account payee cheques drawn for an amount Legal Aspects of Banking
not exceeding Rs. 50,000/- to the account of their customers who are co-operative Operations (CHEQUES)
credit societies, if the payees of such cheques are the constituents of such co-
operative credit societies.
NOTES
Double Crossing
A cheque bearing a special crossing is to be collected through the banker
specified therein. It cannot , therefore, be crossed specially again to another banker,
i.e., cheque cannot have two special crossings, as the very purpose of the first
special crossing is frustrated by the second one. However, there is one exception
to this rule for a specific purpose. If a banker, to whom the cheque is originally
specially crossed submits it to another banker for collection as its agent, in such a
case the latter crossing must specify that it is acting as agent for the first banker to
whom the cheque is specially crossed.

CHECK YOUR
2.5 Endorsement PROGRESS

Definition of Endorsement What is

Section 15 defines endorsement as follows: endorsement?
"When the maker or holder of a negotiable instrument signs the same,
otherwise than as such maker, for the purpose of negotiation, on the back or face
thereof or on a slip of paper annexed thereto or so signs for the same purpose a
stamped paper intended to be completed as a negotiable instrument, he is said to
have endorsed the same and is called endorser.
Thus, an endorsement consists of the signature of the maker (or drawer)
of a negotiable instrument or any holder thereof but it is essential that the intention
of signing the instrument must be negotiation, otherwise it will not constitute an
endorsement. The person who signs the instrument for the purpose of negotiation
is called the 'endorser' and the person in whose favour instrument is transferred is
called the 'endorsee'. The endorser may sign either on the face or on the back of
the negotiable instrument but according to the common usage, endorsements are
usually made on the back of the instrument. If the space on the back is insufficient
for this purpose, a piece of paper, known as 'allonge' may be attached thereto for
the purpose of recording the endorsements.

Legal Provisions regarding Endorsements

The following provisions are contained in the Act as regards endorsements:
(1) Effect of Endorsements. The endorsement of a negotiable instrument
followed by delivery transfers the endorsed property therein with the right of further
negotiation (Section 50). Thus the endorsee acquires property or interest in the
instrument as its holder. He can also negotiate it further. (His right can, of course,
be restricted by the endorser in case of a restrictive endorsement.)

Section 50 also permits that an instrument may also be endorsed so as to

constitute the endorsee an agent of the endorser. -
(1) to endorse the instrument further, or
(2) to receive its amount for the endorser or for some other specified person.

Banking Laws and

Operations - I (25)
Banking Laws and The examples of such endorsements are as follows:
Operations - I
(i) Pay C for my use.
(ii) Pay C or order for the account
Where a negotiable instrument is endorsed for any of the above purposes,
NOTES
the endorse becomes its holder and property therein is passed on the endorsee. In
Mothireddy vs. Pothireddy (A.I.R. 1963, A.P. 313) the Andhra Pradesh High Court
also held that "the right based on the endorsement having made for a specific
purpose, namely, collection of the amount, will be valid till that purpose is served."
The ordinary law regarding agency does not, therefore, apply in such cases.
(2) Endorser. "Every sole maker, drawer, payee or endorsee or all of several
join makers, payees or endorses of a negotiable instrument may endorse and
negotiate the same." This is subject to the condition that the right to negotiate has
not been restricted or excluded (Section 51). Thus in case the instrument is held
jointly by a number of persons, endorsements by all of them is essential. One
cannot represent the other. The absence of the words "or order" in the instrument
or endorsement thereon does not restrict further negotiation.
For example a bill is drawn payable to A or order. A endorses it to B but
the endorsement does not contain the words "or order" or any equivalent words. B
may further negotiate the instrument.
It is, however, essential that the maker or drawer or drawer of an instrument
must have lawful possession over it, i.e., he must be its holder in order to enable
him to endorse o negotiate it. A payee or an endorsee of the instrument must be its
holder for eth same purpose.

(3) Time. A negotiable instrument may be negotiated until its payment has
been made by the banker, drawee or acceptor at or after maturity but not thereafter
(Section 60).

(4) Endorsement for a part of the amount. The instrument must be endorsed
for its entire amount. Section 56 provides that "no writing on a negotiable instrument
is valid for the purpose of negotiable if such writing purports to transfer only a part
of the amount appearing to be due on the instrument." Thus an endorsement for a
part of the amount of the instrument is invalid. But in case an instrument has been
partly paid, it may be negotiated for the balance of the amount provided a note to
that effect is given on the instrument (Section 56). If the endorser intends to transfer
the document to two or more endorsees separately, it will not constitute a valid
endorsement.

(5) The legal representative of a deceased person cannot negotiate by

delivery only, a promissory note, bill of exchange or cheque payable to order and
endorsed by the deceased but not delivered (Section 57). If the endorser dies after
endorsing the instrument payable to order but without delivering the same to the
endorsee, such endorsement shall not be valid and his legal representative cannot
complete its negotiation by mere delivery thereof.

(6) Unless contrary is proved it is presumed under Section 118 that "the
endorsements appearing upon a negotiation instrument were made in the order in
which they appear thereon." It means that the endorsement which appears on an
instrument first is presumed to have been made earlier to the second one.

Banking Laws and

(26) Operations - I
General Rules regarding the Form of Endorsements Legal Aspects of Banking
An endorsement must be regular and valid in order to be effective. The Operations (CHEQUES)
appropriateness or otherwise of a particular form of endorsement depends upon
the practice amongst the bankers. The following rules are usually followed in this
regard. NOTES
1. Signature of the endorser. The signature on the document for the purpose
of endorsement must be that of the endorser or any other person who is duly
authorized to endorse on his behalf. If a cheque is payable to two persons, both of
them should sign their names in their own handwriting. If the endorser signs in
block letters, it will not be considered a regular endorsement.
2. Spelling. The endorser should spell his name in the same way as his
name appears on the cheque or bill as its payee or endorsee. If his name is mis-
spelt or his designation has been given incorrectly, he should sign the instrument in
the same manner as given in the instrument. Thereafter, he may also put his proper
signature in the same handwriting, if he likes to do so. For example, if the payee's
name is wrongly spelt as 'Virendra Perkash' instead of 'Virendra Prakash' regular
endorsement will be as follows: CHECK YOUR
Virendra Prakash Merely writing the correct name will not be regular PROGRESS
endorsement.
Describe legal aspects
3. No addition or omission of initial of the name. An initial name should of a paying banker?
neither be an added nor omitted from the name of the payee or endorsee as given
in the cheque. For example, a cheque is payable to S.C. Gupta should not be
endorsed as S. Gupta or vice versa. Similarly, a cheque payable to Harish Saxena
should not be endorsed as H. Saxena because it will be doubtful for the paying
banker to ascertain that H. Saxena is Harish Saxena and nobody else. It is possible
that some Hari Saxena has signed on the cheque as H. Saxena.

4. Prefixes and suffixes to be excluded. The prefixes and suffixes to the

names of the payee or endorsee need not be included in the endorsement. For
example, the words "Mr., Messrs, Mrs., Miss, Shri, Shrimati, Lala, Babu, General,
Dr., Major, etc." need not be given by the endorser otherwise the endorsement will
not be regular. However, an endorser may indicate has title or rank, etc., after his
signature. For example, a cheque payable to Mojor Raja Ram or Dr. Laxmi Chandra
may be endorsed as 'Raja Ram, Major' or Laxmi Chandra, M.D.' A cheque payable
to Padmashri Vishnu Kant may be endorsed as Vishnu Kant, Padmashri.

2.6 Legal Aspects of A Paying Banker

Law relating to payment of cheques and the role and responsibility of
paying banker is clearly spelt out under Negotiable Instruments Act. There are
circumstances under which banks get protection as a paying banker. At the same
time, they do not get protected if they are found wanting in taking necessary
precautions as a prudent banker. Law is specific and clear-cut as to when they can
seek protection under Negotiable Instruments Act and when they cannot. The
concept of payment in due course is very relevant in establishing whether a payment
is in order or otherwise. Knowledge about the legal aspects governing the payment
of cheques under various circumstances is a must to function as a banker as also
to seek protection under Negotiable Instruments Act. This section deals with all
those pertinent matters in good detail.
Banking Laws and
Operations - I (27)
Banking Laws and 2.6.1 Negotiable Instruments Act and Paying Banker
Operations - I
The relationship between a customer who has deposited money with the
bank and the banker is one of creditor and debtor. The customer who has deposited
money with the bank has the right to withdraw. It is the duty of the banker to pay
NOTES the money on demand or after the expiry of the period for which deposit is kept
depending upon whether it is a demand deposit or a term deposit. In the case of
demand deposit signified by savings bank account or current account banker has
to pay the money on demand. Duty on the part of the banker is laid down under
section 31 of Negotiable Instruments Act, 1881 which states as under:
"The drawee of a cheque having sufficient funds of the drawer in his
hands properly applicable to the payment of such cheque must pay the cheque
when duly required to do so. And in default of such payment, must compensate the
drawer for any loss or damage caused by such default."
1. Section 31 applies to bankers only. The drawee in the case of a cheque is the
banker and banker only. You may recall the definition of the term 'cheque'
which runs as follows:
"Cheque is a bill of exchange drawn on a specified banker and not expressed
to be payable otherwise than on demand."
2. Availability of sufficient balance in the account is the pre-requisite i.e. if
there is no balance in the account, there is obligation to pay on account of the
cheque drawn on a banker.
3. The balance available in the account should be properly available to the
payment of the cheque. Under the following circumstances, balance in the
account may not be available for payment:
- Where the banker has exercised, his right to set off for amounts due from
the customer.
- Where there is an order passed by a court, competent authority or other
lawful authority restraining the bank from making payment.
4. The banker is duly-bound to pay the cheque only when he is duly required to
do so. If the cheque is not properly drawn, there is no obligation of payment
arising there from.
5. In case the banker refuses payment wrongfully, then he is liable only to the
drawer of the cheque and not to any endorsee or holder except when:
- The bank is wound up, in which case the holder become the creditor to
make a claim.
- The banker pays a cheque disregarding the crossing; the true holder can
hold the banker liable.
6. A banker is liable to the drawer for any loss or damage which may have
occurred to the drawer due to the wrongful dishonor of the customer's cheque.
2.6.2 Protection to Paying Banker
(a) For a paying banker to claim protection under the Negotiable Instruments
Act, one of the criteria he has to satisfy is that the payment is in due course. As to
what is payment in due course has been stated in Section 10 which reads as follows:
"Payment in due course" means payment in accordance with the apparent
tenor of the instrument in good faith and without negligence to any person in
possession thereof under circumstances which does not afford a reasonable ground
for believing that he is not entitled to, receive payment of the amount therein
Banking Laws and
mentioned.
(28) Operations - I
 From the above definition it can be seen that payment in due course requires Legal Aspects of Banking
the payment to be made: Operations (CHEQUES)
- in accordance with the apparent tenor of the instrument;
- in good faith;
NOTES
- without negligence;
- to the person in possession of the instrument; and
- while making payment the banker should not have reasons to believe'
that the person in possession of the instrument is not entitled to receive payment of
the amount mentioned in the instrument.

(b) Section 85 of the Negotiable Instruments Act, 1881 grants protection

to a banker on his making payment on a cheque. Though this principle may sound
as a simple logic it is to be noted that the protection granted as per Section 85 is not
absolute.

Section 85 of the Negotiable Instruments Act, 1881 reads as follows:

Section 85
1. Where a cheque payable to order purports to be endorsed by or on behalf of
the payee, the drawee is discharged by payment in due course.
2. Where a cheque is originally expressed to be payable to bearer, the drawee
is discharged by payment in due course to the bearer thereof, notwithstanding
any endorsement whether in full or in blank appearing thereon, and
notwithstanding that any such endorsement purports to restrict its further
negotiation.

Paying banker should ensure that the cheque is regular in all respects and
should take the precautions while making payment of the cheque:
1. The cheque must have been drawn properly. It is interesting to note that
Negotiable Instruments Act defines a cheque but does not prescribe it's from.
It does not even say that it should be drawn on the printed form issued by the
bank. Strictly speaking, a banker cannot refuse to honour a cheque drawn on
piece of paper provided it carries an unconditional order to the banker and
fulfills other requirements of a cheque. But by tradition and custom, banks all
over recognize only the cheque drawn on the printed form issued by the
bank. Accordingly, if customer demands that the payment be made on the
basis of a letter other than by way of a cheque, the banker should permit
such request. However he can demand stamped discharge. We are aware
that in the case of cheque, it need not be stamped. This exemption is accorded
to cheques, of they are in the prescribed format.
2. A cheque must bear a date because the mandate of the customer to the
banker becomes legally effective on the date mentioned therein. The date
should not be incomplete. If the drawer mentions a date earlier to the date of
writing then it is called an ante-dated cheque. In India, a cheque is treated as
stale cheque after the expiry of three months from the date of the cheque. If
the drawer mentions a date on the cheque, which is subsequent to the date
on which it is drawn, it is called a post-dated cheque. Paying banker should
not make payment of a post-dated cheque before the dale mentioned therein.
Otherwise, he will be liable as follows:
- If the drawer instructs the banker, before the date mentioned in the cheque,
Banking Laws and
not to make payment of the post-dated cheque, the banker cannot debit his
Operations - I (29)
Banking Laws and account with the amount of the cheque. If the banker had paid the cheque, it
Operations - I would be deemed as payment made without authority of the drawer.
- If as a consequence of payment of a post-dated cheque by the bank, any
other cheque issued by the drawer is dishonored on the ground of insufficiency
NOTES of funds, the drawer will be entitled to claim damages for its dishonor under
section 31 of Negotiable Instrument Act.
- If the customer unfortunately dies, becomes insolvent after the banker has
made the payment but before the date mentioned in the cheque, the amount
cannot be debited to the customer's amount account because his mandate
becomes ineffective on his demise.
- Payment of a post-dated cheque before the date of the cheque is not
considered as payment in due course. The banker, therefore, can not avail
the statutory protection under section 85. But its payment on or after the
date of the cheque is valid and the banker will bear no liability in this regard.

Paying banker must refuse payment of the cheque under the following
CHECK YOUR
circumstances:
PROGRESS
1. When the drawer countermands the payment:
Describe Legal A cheque is an unconditional order of the drawer to the baker. The drawer
Aspects of Collection is competent to cancel or withdraw such order at any time before its payment is
of A Cheque? made. The drawer need not explain the reason for stopping payment of a cheque.
2. Death of the drawer:
On receipt of reliable information about the death of the customer, the
banker must stop payment of the cheques signed by him because the order of the
customer to the bank ceases to operate on the occurrence of his death.
3. Insolvency of the drawer:
If the debtor commits an act of insolvency as defined in the insolvency
Law, either he or any of his creditors may present a petition in the court of law for
an order of adjudication. When the court issues an order of adjudication, the whole
property of the insolvent person (with certain exceptions) vests in the court or an
official receiver and becomes available for distribution among the creditors.
The banker must stop payment from customer's account as soon as he
receives the information that an insolvency petition has been filed by or against the
customer.

2.7 Legal Aspects of Collection of A Cheque

Collection of cheques, bills of exchange and other instruments on behalf of
a customer is an indispensable service rendered by a banker to his customer. When
a customer of a banker receives a cheque drawn on any other banker he has two
options before him - (i) either to receive its payment personally or through his
agent at the drawee bank, or (ii) to send it to his banker for the purpose of collection
from the drawee bank. In the latter case the banker, deputed to collect the amount
of the cheque from another banker, is called the 'collecting banker'. He presents
the cheque for encashment to the drawee banker and on its realization credits the
account of the customer with the amount so realized.
A banker is under no legal obligation to collect his customer's cheques but
Banking Laws and collection of cheques has now become an important function of a banker with the
(30) Operations - I
growth of banking habit and with wider use of crossed cheques, which are invariably Legal Aspects of Banking
to be collected through a banker only. While collecting his customer's cheques, a Operations (CHEQUES)
banker acts either
(i) as a holder for value, or
(ii) as an agent of the customer. NOTES
The legal position of the collecting banker, therefore, depends upon the
capacity in which he collects the cheques. If the collecting banker pays to the
customer the amount of the cheque or credits such amount to his account and
allows him to draw on it, before the amount of the cheque is actually realized from
the drawee banker, the collecting banker is deemed to be its 'holder for value'. He
takes an undertaking from the customer to the effect that the latter will reimburse
the former in case of dishonour of the cheque.

2.8 Banker as a holder for value

A banker becomes its holder for value by giving its value to the customer
in any of the following ways:
(a) by lending further on the strength of the cheque;
(b) by paying over the amount of the cheque or part of it in cash or in account
before it is cleared;
(c) by agreeing either then or earlier, or as a course of business, that customer
may draw before the cheque is cleared;
(d) by accepting the cheque in avowed reduction of an existing overdraft;
and
(e) by giving cash over the counter for the cheque at the time it is paid in for
collection.
In any of these circumstances the banker becomes the holder for value
and also the holder in due course. He bears the liability and possesses the rights
enjoyed by the holder for value. If the last but one endorsement is proved to be
forged, he will be liable to the true owner of the cheque. But he shall have the right
to recover the money from the last endorser, i.e., his own customer, if the customer
is unable to pay, the banker himself will bear the loss. If the cheque sent for
collections returned dishonoured, the collecting banker can sue all the previous
parties after giving them notice of dishonour. It is, however, essential that the amount
of the cheque is paid to the customer in good faith.

2.9 Collecting Banker as an Agent

A collecting banker acts as an agent of the customer if he credits the
latter's account with the amount of the cheque after the amount is actually realized
from the drawee banker. Thereafter the customer is entitled to draw the amount of
the cheque. The banker thus acts as an agent of the customer and charges from
him a commission for collecting the amount from outstation banks.
As an agent of his customer, the collecting banker does not possess title to
the cheque better than that of the customer. If the customer has no title thereto, or
his title is defective, the collecting banker cannot have good title to the cheque. In
case the cheque collected by him did not belong to his customer, he will be held
liable for conversion of money, i.e., illegally interfering with the rights of true owner
of the cheque.
Banking Laws and
Operations - I (31)
Banking Laws and
Operations - I 2.10 Conversion by the Collecting Banker
Sometimes a banker is charged for having wrongfully converted cheques
to which his customer had no title or had defective title. Conversion means wrongful
NOTES
or unlawful interference (i.e., using, selling, occupying or holding) with another
person's property which is not consistent with the owner's right of possession.
Negotiable instruments are included in the term 'property' and hence a banker may
be charged for conversion if he collects cheques for a customer who has no title or
defective title to the instrument. The basic principle is that rightful owner of the
goods can recover the same from anyone who takes it without his authority and in
whose hands it can be traced. When the banker acts as an agent of his customer
for the collection of his cheques, he cannot escape this liability.
However, the right of the true owner is a restricted one and cannot be
exercised in case the goods reach the hands of one who (i) receives it in good faith,
(ii) for value, and (iii) without the knowledge that the other party had no authority
thereon. Except these circumstances, the true owner of the goods (including the
CHECK YOUR negotiable instrument) can file a suit for conversion.
PROGRESS

What are the Duties of 2.11 Statutory Protection to Collecting Bank

the Collecting Bank?
Section 131 of the Negotiable Instruments Act grants protection to a
collecting banker and reads as follows:
Section 131
Non-liability of a banker receiving payment of cheque: A banker who has
in good faith and without negligence received payment for a customer of a cheque
crossed generally or specially to himself shall not, in case the title to the cheque
proves defective, incur any liability to the true owner of the cheque by reason only
of having received such payment.
Explanation: A banker receives payment of a crossed cheque for a customer
within the meaning of this section notwithstanding that he credits his customer's
account with the amount of the cheque before receiving payment thereof.
The provisions of the above section has been applied to drafts as per
Section 131 A of the Negotiable Instruments Act.
Conditions for protection: Though Section 131 grants protection to a
collecting banker, the protection is not unconditional. For the collecting banker to
claim the protection under Section 131 he has to comply with certain conditions
and they are:
1. The collecting banker should have acted in good faith.
2. He should have acted without negligence.
3. He should receive payment for a customer.
4. The cheque should be crossed generally or specially to himself.

2.12 Duties of the Collecting Bank

Section 131 of the Negotiable Instruments Act which affords protection to
the collecting bank requires amongst other conditions, that the bank should not
have been negligent. To show that the bank has not been negligent the bank will
Banking Laws and have to prove that it has taken all precautions that would be required of a prudent
(32) Operations - I
banker in collecting a cheque. Over the years based on practice and judicial Legal Aspects of Banking
pronouncements, these precautions have been laid down as duties imposed on Operations (CHEQUES)
bankers, the non-compliance of which can make the bank liable on the grounds of
negligence. These duties examined as under
NOTES
(a) Duty to open the account with references and sufficient documentary
proof
The duty to open an account only after the new account holder has been
properly introduced to is too well grained into today's banker's mind that it would
be impossible to find an account without introduction. The necessity to obtain
introduction of a good customer is to keep off crooks and fraudsters who may
open accounts to collect forged cheques or other instruments. As an added precaution
RBI has insisted that while opening accounts photograph of the customer and
sufficient documentary proofs for constitution and address be obtained.
In this regard the English Decision Ladbroke v. Todd (1914) 30 TLR 433
can be referred to. In this case a thief stole a cheque in transit and collected the
same through a banker where he had opened an account without reference and by
posing himself as the payee whose signature the thief forged. After the cheque
was collected the thief withdrew the amount. The bank was held liable to make
good the amount since it acted negligently while opening the account in as much as
it had not obtained any reference.
The conditions to be satisfied for claiming protection under Section 131 of
the Negotiable Instruments Act are: (a) that the banker should act in good faith and
without negligence in receiving payment, i.e. in the process of collection, (b) that
the banker should receive payment for a customer, i.e. act as mere agent in the
collection of the cheque, and not on his account as holder, (c) that the person for
whom the banker acts must be his customer, and (d) that the cheque should be one
crossed generally or specially to himself. The High Court stated that if the draft
was drawn in favour of a fictitious person, it could not be said that the ownership
stood transferred to a non-existent person for the purpose of examining the question
whether the bank as a collecting banker acted negligently or not. The ownership
would pass to the true owner. The High Court did not consider it necessary to
decide as to what extent a person obtaining a draft in favour of a fictitious person
would lose the ownership in favour of a bona fide "holder in due course".
In view of the aforesaid, the Appellant Bank was held to have acted without
taking any care, and was found negligent throughout and was not entitled to the
protection under Section 131 of the Negotiable Instruments Act.

(b) Duty to confirm the reference where the referee is not known or has
given reference in absentia
Though as a matter of practice bankers in India require introduction by an
existing customer of the bank, this may not always be possible especially when the
branch is newly opened. In such cases the customers are required to get references
from known persons in the locality or from the existing bankers. In such case the
banker is required to make enquiries with the referee to confirm that the person
whose account is newly opened is a genuine person.
In Harding v. London Joint Stock Bank [1914] 3 Legal Decision Affecting
Bankers 81, an account was opened for a new customer after complying with the
necessary formalities. The account was not opened by deposit of cash as is the
usual practice but was opened by paying in a third party cheque. The bankers in
the case made enquiries with the customer who thereupon produced a forged
letter issued by his employer giving him power to deal with the cheque. It was Banking Laws and
Operations - I (33)
Banking Laws and thereafter found that the cheque was stolen by the customer and credited to his
Operations - I account. The bank was held negligent for failure to make necessary enquiries
from the employer as to whether the customer who was an employee had in fact
the necessary power to deal with the cheque.
NOTES
(c) Duty to verify the instruments or any apparent defect in the instruments
Sometimes the instrument which is presented for collection would convey
to the banker a warning that a customer who has presented the instrument for
collection is either committing a breach of trust or is misappropriating the money
belonging to some other. In case the banker does not heed the warning which is
required of a prudent banker then he could be held liable on the grounds of negligence
as can be seen from the following cases:
(a) In Underwood Ltd. v. Bank of Liverpool Martin Ltd. [1924] 1 KB 775,
the Managing Director of a company paid into his private account large
number of cheques which were to be paid into the company's account
and the bank was held negligent since it did not make enquiries as to
whether the Managing Director was in fact entitled to the amounts
represented by these cheques.
(b) In Savory Company v. Llyods Bank [1932] 2 KB 122, the cheques which
were payable to the employer was collected by the employee in a private
account opened by him and the bank was held liable for negligence.
In this case two dishonest clerks of a Stock Broker stole bearer cheques
belonging to their employer which were collected in an account maintained
by one of the clerks and in another account in his wife's name. It was
held that the bank had been negligent in opening the clerks account in as
much as they had not obtained his employer's name while opening the
account and that in the case of his wife's account the bank was negligent
in as much as it had not obtained the husband's occupation and his
employer's name while opening the account.
(c) In the case of Australia and New Zealand Bank v. Ateliers de
Constructions Electriques de Cherleroi [1967] 1 AC 86 PC, an agent paid
his principal's cheque into his personal account and the bank was charged
with conversion. However, the bank defended the same on the grounds
that there was implied authority from the principal to his agent to use his
private account for such purpose. Though the banker was negligent in
dealing with the cheques without specific authority the bank escaped
liability since it was found that the principal had in fact authorized his
agent to use his private account.
(d) In Morrison v. London County and Westminster Bank Ltd. [1914-5] All
ER Rep 853, the Manager of the plaintiff was permitted to draw cheques
per pro his employer and he drew some cheques payable to himself which
he collected into his private account. The bank was held negligent for
collecting such
cheques without making necessary enquiries even though there was a clear
indication that the Manager was signing as an agent of the firm.
(d) Duty to take into account the state of customer's account
The collecting banker is required to take into account the status of the
customer and also the various transactions that have taken place in the
customer's account so as to know the circumstances and the standard of
Banking Laws and living of the customer. If for example, a person is an employee and the
(34) Operations - I
 nature of his employment is that of a clerk his salary would be known to Legal Aspects of Banking
the bank and any substantial credits by way of collection of cheques Operations (CHEQUES)
would be suspected and it would be the duty of the banker to take necessary
precautions while collecting such cheques.
(e) Negligence of collecting bank in collecting cheques payable to third parties NOTES
The collecting bank has to make necessary enquiries before any third
party cheques are collected on behalf of its customer. In Ross v. London County
Westminster and Parrs Bank Ltd. [1919] 1 KB 678, cheques payable to "the Officer
in charge, Estate Office, Canadian Overseas Military Force" were used by an
individual to pay off his debts. There was an instruction in all the cheques that it
was negotiable by the concerned officer. However, it was held that the fact that
the cheques were drawn in favour of the Officer in charge should have put the
banker on enquiry and since no such enquiry was made by the banker the bank is
liable on the grounds of negligence.

2.13 Key Concepts

Cheque
A cheque is defined in Sec 6 of NI Act as under :-
(i) A cheque is a bill of exchange drawn on a specified banker
(ii) Payable on demand
(iii) Drawn on a specified banker
(iv) Electronic image of a truncated cheque is recognized under law.
Crossing of a Cheque
A cheque bearing such an instruction is called a 'crossed cheque'; others
without such crossing are 'open cheques' which may be encashed at the counter of
the paying banker as well.
Endorsement
"When the maker or holder of a negotiable instrument signs the same,
otherwise than as such maker, for the purpose of negotiation, on the back or face
thereof or on a slip of paper annexed thereto or so signs for the same purpose a
stamped paper intended to be completed as a negotiable instrument, he is said to
have endorsed the same and is called endorser.

2.14 Summary
l A cheque is nothing but a bill of exchange with special features A cheque is
classified as 'Open' when cash payment is allowed across the counter of the
bank.
l A cheque which is payable to any person who holds and presents it for
payment at the bank counter is called a 'Bearer cheque'.
l An order cheque is a cheque which is payable to a particular person. Crossing
is an 'instruction' given to the paying banker to pay the amount of the cheque
through a banker only and not directly to the person presenting it at the
counter. Banking Laws and
Operations - I (35)
Banking Laws and l Thus, an endorsement consists of the signature of the maker (or drawer) of
Operations - I a negotiable instrument or any holder thereof but it is essential that the intention
of signing the instrument must be negotiation, otherwise it will not constitute
an endorsement.
NOTES l An endorsement must be regular and valid in order to be effective.
l The Negotiable Instruments Act,1881 deals with negotiable instruments like
promissory notes, bills of exchanges, cheques and similar payment instruments
such as demand drafts, dividend warrants, etc.
l When a customer of a banker receives a cheque drawn on any other banker
he has two options before him (i) either to receive its payment personally or
through his agent at the drawee bank, or (ii) to send it to his banker for the
purpose of collection from the drawee bank.
l A banker is under no legal obligation to collect his customer's cheques but
collection of cheques has now become an important function of a banker
with the growth of banking habit and with wider use of crossed cheques,
which are invariably to be collected through a banker only.
l A collecting banker acts as an agent of the customer if he credits the latter's
account with the amount of the cheque after the amount is actually realized
from the drawee banker.

2.15 Exercise
Fill in the blanks
1. The person who transfers his right to another person is called as ________.
(Endorsee, Endorser, Drawer)
2. The person to whom the right is transferred is called as__________.
(Endorsee, Endorser, Drawee)
3. A cheque bearing an instruction given to the paying banker to pay the amount
of the cheque through a banker only and not directly to the person presenting
it at the counter is called a '_________'.
(Bearer cheque, Crossed cheque, Order cheque)
4. "When the maker or holder of a negotiable instrument signs the same,
otherwise than as such maker, for the purpose of negotiation, on the back or
face thereof or on a slip of paper annexed thereto or so signs for the same
purpose a stamped paper intended to be completed as a negotiable instrument,
he is said to have ___________ the same and is called endorser.
(Crossed, Endorsed, Paid)
5. In case the instrument is held jointly by a number of persons, endorsements
by ________ is essential.
(None of them, One of them, All of them)
6. "Cheque is a bill of exchange drawn on a specified banker and not expressed
to be payable otherwise than on _______."
(Order, Demand, Request)
7. If the collecting banker pays to the customer the amount of the cheque or
credits such amount to his account and allows him to draw on it, before the
amount of the cheque is actually realized from the drawee banker, the
collecting banker is deemed to be its '_________ for value'.
Banking Laws and (holder , agent, collector)
(36) Operations - I
8. ___________ means wrongful or unlawful interference (i.e., using, selling, Legal Aspects of Banking
occupying or holding) with another person's property which is not consistent Operations (CHEQUES)
with the owner's right of possession.
(Conversion, Acquisition, Holding)
NOTES
[ANS: 1)Endorser 2)Endorsee 3)Crossed cheque 4)Endorsed 5)All of them
6)Demand 7)Holder 8)Conversion]

2.16 Further Readings & References

1. M.L.Tannan, revised by : Banking Law and Practice, Wadhwa & Company,
Nagpur C.R. Datta & S.K. Kataria
2. A.B. Srivastava and : Seth's Banking Law, Law Publisher's India (P) Limited
K. Elumalai
3. R.K. Gupta : BANKING Law and Practice in 3 Vols. Modern Law Publications.
4. Prof. Clifford Gomez : Banking and Finance - Theory, Law and Practice, PHI
Learning Private Limited
5. J.M. Holden : The Law and Practice of Banking, Universal Law Publishing.

Banking Laws and

Operations - I (37)
Banking Laws and
Operations - I UNIT 3
LEGAL ASPECTS OF BANKING
NOTES
OPERATIONS
2. Indemnities & Guarantees
Structure
3.0 Introduction
3.1 Objectives
3.2 Contract of Indemnity
3.3 Application of Indemnity Contracts to Banks
3.4 Rights of an Indemnity Holder
3.5 Time of commencement of the indemnifier's liability:
3.6 Damages
3.7 Bank Guarantee
3.8 Types of Guarantee
3.9 Banker's Duty to Honour Guarantee
3.10 Issuance of Bank Guarantee - Precautions to be taken
3.11 Payments Under Bank Guarantee -Precautions to be taken
3.12 Key Concepts
3.13 Summary
3.14 Exercise
3.15 Further Readings & References

3.0 Introduction
Banks maintain operating accounts like Savings Bank, Current, Overdraft
and Cash Credit accounts which are operated by the cheques drawn by the account
holders on their bankers. While handling these cheques, a banker may act as a
paying banker (when cheques are drawn on him) or collecting banker (when cheques
are deposited with him). Banks are under statutory obligation to honour a cheque
and make payment if it is in order as per relevant laws. As a collecting banker, he
should collect the cheques only for his customer and as per the provisions of the
legal frame work the Negotiable Instruments Act,1883. Legal aspects in banking
operations such as indemnities and guarantees are important in banker's point of
view.

3.1 Objectives
After reading this unit, you should be able :
- To understand the important aspects of the role of a banker as paying
and collecting banker
- To know about the legal aspects of banking operations and the precautions
taken by banks
- To understand the legal aspect of Indemnities and Guarantees
Banking Laws and
(38) Operations - I
 Legal Aspects of Banking
3.2 Contract of Indemnity Operations (Indemnities
& Guarantees)
The law relating to indemnity as laid down by section 124 and 125 of
Indian Contract Act is not exhaustive. It is much wider than what is stated in
NOTES
Contract Act. It is much enriched by judgments and interpretations of various law
courts from time to time. Students are therefore well-advised to go beyond the
confines of bare definitions and limited expiations provided in the text of law and
reach the world wisdom by way of references to such rich material on this subject.

Section 124 of Indian Contract Act defines contract of indemnity as under:

"A contract by which one party promises to save the other form loss caused
to him by the conduct of the promisor himself or by the conduct of any other
person is called a contract of indemnity."
The person who promises to make good the loss is called the indemnifier
(promisor) and the person whose loss is to be made good is called the indemnified
or indemnity holder (promise). A contract of indemnity is a class of contingent
contracts. CHECK YOUR
PROGRESS
Example
A and B claim certain goods from a Railway company as rival owners. A Describe Contract of
takes delivery of the goods by agreeing to compensate the railway company against Indemnity?
loss in case, B turns out to be the true owner. There is a contract of indemnity
between A and the railway company.
The definition of contract of indemnity as given in the Indian contract Act
is not exhaustive. It is an inclusive definition. It includes:
- Express promises to indemnify
- Cases where the loss is caused by the conduct of the promisor himself or
by the conduct of any other Person
It does not include:
- Implied promises to indemnify.
- Cases where loss arises from accidents and events not depending on the
conduct of the promisor or any other person.
In India, it has been held that sections 124 and 125 of the contracts Act are
not exhaustive and the courts here would apply the same equitable principles that
the courts in England do. Moreover, if section 124 is strictly interpreted, even
contracts of insurance would have to be excluded from this definition. It may be
submitted that such a strict application of the definition was not intended by the
Legislature.
A contract of indemnity may be express or implied. An implied contract of
indemnity may be inferred from the circumstances of the case or from relationship
of the parties.
Example: A is the owner of an article. X sends it to Y, an auctioneer, for
sale. Y sells the article. Claims it and recovers damages from Y for selling it. Y can
recover the loss form X as a promise by X to save Y from any such loss would be
implied from his conduct in asking Y to sell the article.

Section 69 also implies a promise to indemnify. It goes like this:

'A person who is interested in the payment of money which another is
bound by law to pay, and who, therefore pays it, is entitled to be reimbursed by the
other. Banking Laws and
Operations - I (39)
Banking Laws and A contract of indemnity is a species of the general contract. As such it
Operations - I must have all the essential elements of a valid contract, viz., consideration,
competency of the parties, free and genuine consent, and legality of the object
contracted for.
NOTES In an indemnity, the risk is contingent whereas in a guarantee the liability is
subsisting. In a contract of indemnity, he indemnifier is required to make good the
loss as soon as it occurs and he cannot rely on the fact the person on whose behalf
the indemnity is given has not made good the loss whereas in a contract of guarantee
the surety's liability is coextensive with that of the principal debtor.
There are only two parties to a contract of indemnity and as such only one
contract. However, in a contract of guarantee there are at least three contracts:
one between the debtor and the creditor, the other between the creditor and the
surety and the third between the surety and the debtor. An indemnity is for the
reimbursement of a loss whereas a guarantee is for the security of the creditor.

CHECK YOUR
3.3 Application of Indemnity Contracts to Banks
PROGRESS
As far as a banker is concerned, the law relating to indemnities is of great
importance. In the course of baking business, there are times when customers
Describe Application approach the banks for issue of duplicate demand drafts, deposit receipts and so
of Indemnity on. Although banks do take due care and precaution in the matter of issuing duplicate
Contracts to Banks? instruments, instances are not wanting where claims are made against the banks
by persons who are affected by such issuance.
It is therefore prudent to take required indemnity from those persons at
whose instance duplicate demand drafts deposit receipts are issued.
Let us take the example of issue of duplicate deposit receipt. In the first
instance at the time of receiving the deposit, banks issue deposit receipt in the
name of the depositor or depositors. Deposit receipts are required to be tendered
by the depositor either for raising loan on it or for encashment either prematurely
or on the date of maturity. Possession of the deposit receipt is the only proof of a
person having a deposit subject of course to verification of the specimen signature
and other proof.
Suppose the depositor reports loss of receipts or its misplacement, banker
proceeds to issue a duplicate one as per the system in place. Although baker takes
all the necessary care and precaution to ensure that the person requesting for issue
of duplicate receipt is the one entitled to deposit, there may still be chances of
misrepresentation.
If the true owner were to produce the original deposit receipt, banker will
be in trouble. To obviate such instances (few and far between, of course), banks
do insist upon an indemnity form the person in whose favour such duplicate receipt
is issued.
Same is the case in the matter of issue of duplicate demand drafts. By the
act of issuing duplicate demand drafts, banks are likely to be exposed to claims by
the interested persons and rightful owners. Therefore as prudence calls for it,
indemnity bond is insisted upon from the persons at whose request the duplicate
instruments are issued.
Indemnities are required since the bank has to protect itself from any
subsequent claim made by a person who may have for value received these
instruments. In some cases over and above the indemnity banks ask for sureity.
This is usually done in cases where the amount involved is quite substantial or the
customer is not well-known enough to the banker since the customer must have
Banking Laws and
(40) Operations - I had only one or two dealings with the banker.
 In the indemnity taken by the bank, the customer undertakes to protect the Legal Aspects of Banking
bank from any loss or damage and also for costs incurred. In most of the States, Operations (Indemnities
these indemnities are stamped as an agreement. If they are witnessed, they would & Guarantees)
be treated as an indemnity bond thereby being liable for ad valorem stamp duty.
Whenever bank issues bank guarantee, apart from margin and security, counter NOTES
guarantee may be insisted upon. The customer who requests the banker for issue
of bank guarantee has to execute counter guarantee in favour of the bank. It may
be noted that counter guarantee is in the nature of indemnity in favour of the bank.
Let us have a look at the indemnity letter executed by a customer for issue of
duplicate drafts. Some lines in this letter of indemnity may run as under:
"In consideration of your issuing to me/us a fresh/duplicate draft in lieu of
the above mentioned draft which has been irretrievably lost or mislaid, I/We hereby
agree and undertake to hold you harmless and keep you fully indemnified from and
against all losses, costs or damages which you may sustain or incur by reason of
your issuing this fresh/ duplicate draft or by reason of your issuing this fresh/
duplicate draft or by reason of the original draft being at any time found and presented
for payment.
CHECK YOUR
I/we hereby agree and undertake to hold you harmless and to keep you
PROGRESS
fully indemnified against all claims and damages which may be made in respect
hereof by any person or persons claiming to be the holders of the draft or in any
Describe Rights of an
way interested therein.
Indemnity Holder?
I/we agree and undertake to pay and make good any such losses, damages
or expenses upon demand being made. I/we further agree and undertake to return
to you the original draft should it be found by me/us or again come into/my possession
at any time hereafter."

3.4 Rights of an Indemnity Holder

Section 125 of the Contract Act deals with the rights of indemnity holder.
The promisee in a contract of indemnity, acting within the scope of his
authority, is entitled to recover from the promisor:
- All damages which he may be compelled to pay in any suit in respect of
any matter to which the promise to indemnity applies.
- All costs which he may be compelled to pay in any such suit if, in bringing
or defending it, he did not contravene the orders of the promisor, and acted as it
would have been prudent for him to act in the absence of any contract of indemnity,
or, if the promisor authorised him to compromise the suit.
- All sums which he may have paid under the terms of any promise of any
such suit, if the compromise was not contrary to the orders of the promisor, and
was one which it would heve been prudent for the promise to make in the absence
of any contract of indemnity to compromise the suit.
It may be noted that that the rights of indemnity holder are subject to:
- His acting within the scope of his authority.
- The condition that he does not contravene the specific directions of the
promisor.
In case the indemnity holder does not violate the above two conditions, he
is then entitled to be indemnified by the indemnifier to the extent of:
- The damages paid by him.
- The costs incurred to file the suit
- Any amounts paid by him pursuant to a compromise in the suit provided Banking Laws and
Operations - I (41)
Banking Laws and that the compromise was not contrary to any of the order or directions of the
Operations - I indemnifies and the compromise was such that it was an act of prudence in the
absence of contract of indemnity,
Costs: As regards the costs, costs paid to the solicitors, traveling expenses
NOTES and also costs reasonably incurred in resisting or reducing or ascertaining the claim,
may be recovered. The general principle in computing the costs is that it should be
such as, would a reasonable man think if necessary to incur.
Sums paid on compromise: As per the section, if the indemnity holder acts
within the scope of his authority, then he is entitled to recover from the indemnifier
all the sums that he may have paid pursuant to a compromise in a suit, provided
however that:
a) Such compromise was not contrary to the orders of the indemnifier or
b) Such compromise was prudent to be made by the indemnity holder in
the absence of any contract of indemnity.
c) The indemnifier had authorized the indemnity holder to compromise the
suit.
CHECK YOUR The Madras High Court in Venkataramana v. Magamma (AIR 1944 Mad.
PROGRESS 457) has held that even in the absence of a notice to the indemnifier (promisor), the
compromise would bind him, if not contrary to the orders of the promisor, and is
Describe damages? entered bona fide and without any collusion and is not imprudent.

3.5 Time of commencement of the indemnifier's liability:

Section 124 the Indian Contract Act does not state the time of the
commencement of the indemnifier's liability under the contract. Different High
Court have been observing different rules in this connection. Some High Court
have held that the indemnifier is not liable until the indemnified has incurred an
actual loss. Others have held that the indemnified can compel the indemnifier to
make good his loss even before he has actually discharged his liability. "Indemnity
is not given by repayment after payment Indemnity requires that the party to be
indemnified shall never be called upon to pay."
An observation was made by Chagle J, in the case of Gajanan vs. Moreshwar
that "if the indemnified had incurred a liability and that liability is absolute, he is
entailed to call upon the indemnifier to save him from that liability any pay it off."

3.6 Damages
You may recall that contract of indemnity is a contract by which one party
promises to save the other from loss caused to him. This loss can be either by the
conduct of the promisor or by the conduct of any other person.
The indemnity holder (the promise or the person who is indemnified) has
the following rights when sued (i.e. when a legal action is taken against the person
who is indemnified)
The promise is entitled to recover from the promisor, in respect of the
matter to which the promise to indemnify applies:
1. All damages which he may be compelled to pay in any suit.
2. All costs which he may be compelled to pay in any suit.
Example
A contracts with C that B will not sue C in respect of Rs. 100000/-, which
Banking Laws and
C owes to B. If sues C, any consequences of such a suit will be borne by A
(42) Operations - I
according to the contract. Is such a contract valid? Legal Aspects of Banking
The Contract Act specifically provides that such a contact can be entered Operations (Indemnities
& Guarantees)
into. These are known as contract of indemnity. Here A is said to indemnify C for
a certain loss, which he may suffer.
All insurance contracts are examples of contracts of indemnity because NOTES
all insurance contracts, which indemnify a person from certain losses, which he
may suffer, e.g. under a fire insurance policy taken by a shop-keeper for his godown,
the insurance company undertakes to pay a certain amount to the policy holder
(i.e. the shop-keeper) in the event of fire in the godown and subject to the conditions
of the policy and payment of premium by the shop keeper (policy holder).

3.7 Bank Guarantee

Need for bank guarantee in the commercial and business world is almost
inevitable. Bank customers in their business world are often required to furnish
bank guarantee either in support of their financial strength or performance standards. CHECK YOUR
In the absence of bank guarantees issued by a bank's customers, they would have PROGRESS
had to keep cash as a security. The third party who seeks a guarantee prefers a
bank guarantee for obvious reasons of bank's credibility and their capacity to take Describe bank
the risks of payment. Bank's on the other hand, are in a position to evaluate the guarantee?
customer's standing and assess the needs, as issuing a bank guarantee is often a
part of overall lending by the banks. Banks earn sizeable income in the form of
commission besides being able to expand business. In this unit we shall discuss the
fundamentals about bank guarantee and their types. We shall ponder over the care
and precaution banks need to take at the time of issuance and payment of bank
guarantees.
Bank guarantee is a guarantee given by a bank to a third person, to pay
him a certain sum on behalf of the bank's customer, on the customer failing to fulfill
any contractual or legal obligations towards a third person. The customer at the
instance of whom bank guarantee is issued must have some commitment to fulfill
certain obligations to a third party, for instance, a customer as a contractor may
have to deposit earnest money equal to ten percent of contract sum with the
Government department. Government department offer to accept a bank guarantee
for the like sum in lieu of deposit of earnest money. The customer requests his
bank to issue a bank guarantee favouring the concerned department. Bank guarantee
for a specified sum is for a certain period of time; say for example, a year. If during
this period, the customer (contractor) commits any breach of contract, the
department can invoke the bank guarantee and demand payment of the sum
guaranteed. This is an example of a situation where need for bank guarantee
arises.
The obligation on the part of customer to the third party may be contractual
or legal i.e., imposed by law. This commitment of the customer is guarantee by a
bank and if the customer fails to honour his commitment the banker pays the
amount it has promised to pay. Once the bank gives a guarantee then its commitment
to honour the guarantee is absolute and binding. It therefore, prudent that a banker
secures his position by insisting on a suitable margin or security before issuing a
guarantee on behalf of his customer. Normally, for a known and creditworthy
customer, banker issues bank guarantee with cash margin. For instance, for a bank
guarantee of say Rs.5, 00,000 bank may demand 20 percent cash margin in the
form of deposit. In this case, customer will deposit Rs.1, 00,000 and the deposit
receipt for the sum will be handed to the bank. Costumer will affix his signature on
the back of the deposited receipt by way of discharge. Bank will note its lien as Banking Laws and
Operations - I (43)
Banking Laws and 'Lien to B/G 12/2014. Sometimes, banks may demand 100 percent cash margin.
Operations - I For instance, for issuing a bank guarantee of say Rs.5, 00,000/- banker may demand
a cash margin of Rs. 5,00,000 in the form of deposit. Commission on 100% secured
bank guarantee will be lesser than that of other bank guarantees.
NOTES Where the sum of bank guarantee is on the higher side and the customer
enjoys multiple credit facilities, banks may require the customer to offer mortgage
of immovable properties.

3.8 Types of Guarantee

Following types of bank guarantees issued by banks-
1. Financial guarantee:
These are guarantees issued by banks on behalf of their customers, in lieu
of the customer being required to deposit cash security or earnest money. These
CHECK YOUR kinds of guarantees are mostly issued on behalf of customers dealing with
PROGRESS government departments. Most of the government departments insist that before
the contract is awarded to the contractor, he should show that he is willing to
Describe types of perform the contract and to bind him to perform the contract government
guarantee? departments insist on an earnest money deposit. In lieu of earnest money deposit,
government departments are generally willing to accept a bank guarantee. This
helps customer in as much as he is enabled to utilize the otherwise payable earnest
money deposit for his business purposes. Bank are always willing to help their
clients and hence issuing bank guarantees enables them to earn pretty good
commission besides developing customer contact and loyalty. Normally, a bank
that grants short term and long-term finance will look forward to this business of
issuing bank guarantee as well. In case the contractor does not fulfill his obligation,
then the government departments invoke the guarantee and collect the money
from the banks.
2. Performance Guarantee:
These are the guarantee issued by banks on behalf of its customers whereby
the bank assures a third party that the customer will perform the contract as per
the condition stipulated in the contract, failing which the bank will compensate the
third party to the extent of amount specified in the guarantee. These types of
guarantees are usually issued by banker on behalf of their customers who have
entered into contracts to do certain things on or before a given date. Though the
bank assures that the conditions as stipulated in the contract will be complied with
by the customer in practice the banks on being served a notice of default by third
party pays the amount guaranteed without going into technicality of contract.
Though in certain performance guarantees, a clause is inserted that proof
of default of the customer is necessary, most of the banks do not insist on such
proof. A mere demand by the beneficiary that there has been a default by the
bank's customer is sufficient for the bank to make payment. This is based on the
principle that banks by nature of their expertise and dependability prefer to deal
with documents and they would not like to go beyond the contract. The very sanctity
of guarantee would be lost if banks were to sit in judgment over the proof of
breach. The beneficiary would not care to invoke a bank guarantee just like that.
For him, performance of the terms is more important than its breach. Therefore, it
is in this context that banks honour their commitment immediately upon hearing
from beneficiary about invocation of banks guarantee.
Generally, performance guarantees are not preferred by banks. Here, the
banker is guaranteeing the quality of work and its execution in terms of quality
Banking Laws and
control. It is difficult to guarantee performance to someone. Bankers cannot be
(44) Operations - I
expected to come to the spot where work is going on. These guarantees are issued Legal Aspects of Banking
subject to fixing the liability in financial terms. Performance guarantee is difficult Operations (Indemnities
to monitor and hence, they are issued favoring third parties at the instance of & Guarantees)
customers of unquestionable integrity and performance standards.
3. Deferred Payment Guarantee: NOTES
Under this type of guarantee, the banker guarantees payment of installment
spread over a period of time.
This type of guarantee is required when goods or machinery is purchased
by a customer on credit and the payment is to be made in installments on specified
dates. In terms of the contract of sale, the seller draws drafts (bills) of different
maturities on the customer which is to be accepted by the customer. The banker
guarantees due payment of these drafts. A deferred payment guarantee constitutes
an undertaking on the part of the bank to make payment of deferred installments to
the seller (beneficiary) on due dates in the event of default by the customer (buyer).
While issuing a deferred payment guarantee, the banker has to assess the ability
and sources of funds of the customer to honour the payment of installments on due
dates.
4. Statutory Guarantee:
These are guarantees issued by banks favoring courts and other statutory
authorities guaranteeing the customer will honors his commitments imposed under
law, falling which the bank will compensate the extent of the amount guaranteed.
These are usually given in the form of a bond and the format of these guarantees
is usually drawn up by the courts or concerned authority or are already prescribed
by the statute as per which guarantee is required.
This kind of guarantee is usually given under the code of Civil Procedure,
Customer Act, Central Excise Act, and Major Ports Act and also to authorities like
the Sales Tax Commission, Provident Fund Commission etc.

3.9 Banker's Duty to Honour Guarantee

Bank guarantees from the foundation of trade and commerce. Even though
they are an off shoot of a primary contract between the debtor and creditor, these
guarantees are independent commitments taken by bank on behalf of their customer.
In most bank guarantees, bank undertakes to make payment merely on demand by
the beneficiary.
It, therefore, is absolutely necessary that irrespective of the underlying
contract and dispute between the parties to the contract, the bank makes payment
if the guarantee has been invoked properly.
The obligation of a banker to honour his commitment on a guarantee given
by him being primary casts a duty on the bank to honour it irrespective of the
disputes between the beneficiary and the debtor (customer). Bank, having issued a
bank guarantee owes a duty to pay the amount undertaken in the guarantee as
soon as it is invoked by the beneficiary. Under no pretext can the banker either
deny or defer the payment. Once the liability crystallizes, bank is obliged first to
pay. Its right of recovery arises upon payment of the guaranteed amount.

3.10 Issuance of Bank Guarantee - Precautions to be taken

The liability of bank issuing bank guarantee is based on two factors (a) the
amount guarantee and (b) the period of guarantee. These two aspects need be
Banking Laws and
mentioned in the guarantee unequivocally. In the absence of clarity of either one or Operations - I (45)
Banking Laws and both of these factors, the bank's liability could become unlimited either in terms of
Operations - I amount or period of guarantee. Banker should necessarily obtain a counter guarantee
from his customer on whose behalf he has issued the bank guarantee. In case the
banker is required to pay the guarantee amount, he can fall back on the counter
NOTES guarantee to claim the amount paid by him. We need to know about this a little
more in detail as it helps us in dealing with day-to-day matters on bank guarantee
as bakers.
Amount of guarantee agreed to be mentioned both in figures and words.
While stating the amount, bank should be clear as to whether the amount is inclusive
of interest, charges, taxes etc. Bank should mention a certain amount clearly and
say that it is the only amount payable irrespective of any other claim. In other
words, bank should take care of chances of any loose interpretation at a later
stage. When the bank issues performance guarantee, the mention of amount of
liability in clear and unambiguous terms becomes all the more important.
The period during which the bank guarantee subsists in called the validity
period and the period during which the claim could be preferred in called the claim
period. Bank guarantee's validity period should be specified to exact date, for
example. "This guarantee is valid up to 31 December, 2014." Specific mention
about claim period is equally important as, for example, "Claim under this guarantee
must be made within 3 months from the validity period and the last date of such
claim shall not be later than 31 March 2015." It is necessary to provide for a period
slightly longer than the validity period for the beneficiary to make a claim. The
claim period is usually a few months more the validity period of the guarantee. This
claim period is a sheer necessity as the debtor could possible commit a default
even on the last day of the validity period. Taking in to account the time to
communicate the invocation etc. the claim period should at least be 15 to 30 days
after the validity period, it may even go up to 3 months.
Prior to amendment of Section 28 of the Indian Contract Act, 1872 most
bank guarantees had a standard clause at the end of their guarantee agreement.
As per this clause, the beneficiary was required to enforce his claims within a
period of three to six months, failing which the banks liability was extinguished and
hence the rights of the beneficiary. This clause was necessitated due to the fact
that in the absence of it, Government Departments and Municipal Bodies need to
file a suit against the bank under a bank guarantee within a period of 30 years after
making a claim. The banks would therefore be required to carry forward the liability
for a long period and thereby make provisions for the same in their balance sheet.
Furthermore, cash margin and security furnished by the customer would have had
to be retained for that long a time. Though this clause was challenged before
various High Courts, there was not much relief as Courts held that such clauses
are not violating of Section 28 of the Contract Act. With effect from 1st January,
1987, Section 28 of Indian Contact Act been amended due to which the standard
limitation clauses in the bank guarantees by which the banks extinguished their
liability have been declared illegal.
As such, at present, if a beneficiary were to invoke the guarantee within
the claim period, for a default committed by the debtor during the validity period,
then in case the bank did not make payment, the beneficiary can sue the bank
within the normal period as provided in the Limitation Act, 1963. This period under
the Limitation Act is 30 years in case the beneficiary is a Government Department
or Municipal Body and 3 years in all other cases.
It is prudent therefore that the bank insists that the bank guarantee be
returned after the claim period duly cancelled by the beneficiary or a certificate be
obtained from the beneficiary that there is no claim under the guarantee. Till such
Banking Laws and times, the cash margin and the security of the debtor (customer) have to be retained.
(46) Operations - I
 As bank guarantee is a contingent liability, it is always prudent for a banker Legal Aspects of Banking
to secure this contingent liability in case it is enforced. This can be done by obtaining Operations (Indemnities
a counter guarantee -cum-indemnity executed by the customer in favour of the & Guarantees)
bank. The counter guarantee -cum - indemnity should be carefully drafted to ensure
that in case the bank were to make payment on behalf of the customer, then the NOTES
customer in turn should not only make good the amounts paid by the bank to the
creditor but also any expenses connected therewith including costs of attorney,
any interest on delayed payment, taxes and other levies. It is to take care of all the
payments that the counter guarantee also includes an indemnity aspect. The counter
guarantee should also include a clause that it would remain in force till the guarantee
given by the bank subsists viz., till the bank is duly discharged by the beneficiary or
a certificate to this effect is issued by the beneficiary. Though a counter guarantee-
cum-indemnity is taken as a security for every guarantee issued by the bank, its
values would depend on the financial standing of the person/company giving the
counter guarantee. As such, it is preferable that keeping in mind the financial worth
of the counter guarantor, necessary security in the form of fixed deposits, mortgage
etc. be obtained or the existing charge of the debtor be also extended to cover the
guarantee

3.11 Payments Under Bank Guarantee -Precautions

to be taken
Before making payment, a banker has to ensure that the invocation of the
guarantee has been properly done failing which he may not have any recourse
against the debtor. The banker should also see that no order of injunction has been
passed by any court of law prohibiting the bank from making payment.
In case a banker makes a payment, in spite of there being an order by a
competent court in which the bank is a party, then the bank will be answerable for
contempt of court.
The bank while making payment on its guarantee has to be careful and
has to ensure that the invocation has been properly made. There are divergent
views as regards the proper manner in which a bank guarantee should be invoked.
It is incumbent upon the bank to ensure that invocation of bank guarantee
has been in order; it will do well to see that following requirements are duly complied
with:
- The invocation is well within the claim period.
- The amount claimed by way of invocation is not in excess of what is
guaranteed.
- The authority invoking the guarantee has the powers to do so. In the
case of Government Departments, the authority to invoke bank guarantee is usually
is entrusted to a post by way of allocation of authority. It is the duty of the banker
is make himself doubly sure about the authority invoking the bank guarantee.
Instances of courts granting injunctions restraining the banks from making
payment under a guarantee are there in many cases. In one such case that came
up before Calcutta High Court, injunction was granted. The facts of the case in M/
s G.S. Atwal Co. Engineers (P.) Ltd. v. Hindustan Works Construction Ltd. Are
under; Under the terms of contract entered into between the petitioner and the
respondent, the petitioner was to furnish a bank guarantee for mobilization advance
made by the respondents to the petitioner for Rs. 32.50 lakh. The contract did not
require the petitioner to gives any bank guarantee for the dues performance of the
contract. The petitioner requested the bank to issue a guarantee for Rs. 32.50 lakh Banking Laws and
Operations - I (47)
Banking Laws and to cover the mobilization advance received by the petitioner from the respondent.
Operations - I The bank made use of its standard format of guarantee and did not delete certain
clauses therein as a result of which the guarantee Issued by it became a mobilization
advance - cum - performance guarantee. The respondent took advantage of the
NOTES mistake and although the mobilization advance was recovered in full, it invoked the
bank guarantee for recovery of its claim for damages for loss suffered as a result
of nonperformance of the contract by the petitioner and demanded payment of the
amount guaranteed by it, petitioner approached the High Court for an order
restraining the bank for making payment

The High Court in this case held that:

The respondent was aware of the mistake on the part of the bank and with
ulterior motive took advantage of the mistake by demanding payment of its claim
for damages for non-performance and not in respect of any amount due for
mobilization advance given to the petitioner.
The bank has no right to saddle its customers with any additional liability
under the guarantee by issuing the same contrary to the instructions by its customer.
The respondent has invoked the guarantees foe recovery of loss and
damages alleged to have been suffered due to alleged breach of contract by the
petitioner.
Though the general principles of non-interference by the court in cases of
bank guarantee and letter of credit is for the smooth function of international trades
and commences, this principle would not apply where bank has acted negligently
and issued bank guarantee contrary to the customers' instructions.
Whether the invocations of the bank guarantee was in terms of the
guarantee or not will depend upon the terms of the guarantee and the letter of
invocation. The bank cannot act arbitrarily or whimsically in deciding whether the
invocation was in terms of the guarantee when in fact it was not.
In the instant case, the bank guarantee was for mobilization advance and
not for performance of the contract and the invocation of bank guarantee was
admittedly for recovery of damages for the alleged non-performance was special
equity in favour of the petitioner and he can prevent the beneficiary from enforcing
the bank guarantee. It is therefore absolutely necessary for the bank to confirm
that no injunction order has been issued restraining the bank from making payment.
Banks grant loans and advances (fund based) and provide other credit
facilities (non fund based) such as, bank guarantee and letters of credit. Non fund
based limits are granted by banks to facilitate the customers to carry on with the
trading and business activities more comfortably. Bankers can earn front end fees
and these non fund based items become contingent liabilities for banks.
A contract of guarantee is covered under the Indian Contract Act,1872.
Sec 126 defines a guarantee as contract to perform the promise or discharge a
liability of a third person in case of his default. The contract of guarantee may be
oral or in writing. Banks, however insist on written guarantees.
There are 3 parties to the contract of guarantee. They are called Surety,
Principal Debtor and the Creditor. These parties are also called as the guarantor,
borrower and the beneficiary.
Banks deal with two types of guarantees: (i) Accepted by the bank, and
(ii) Issued by the bank
(1) Guarantees accepted by the Bank:
At the time of lending money, banks accept securities. In addition to the
Banking Laws and tangible assets a borrower arranges to furnish a personal security given by surety
(48) Operations - I
(guarantor). This is called third party guarantee, who undertakes to pay the money Legal Aspects of Banking
to the bank inclusive of interest and other charges, if any, in case the principal Operations (Indemnities
borrower fails to repay or if the borrower commits default. Banks also obtain & Guarantees)
Corporate guarantees issued by companies who execute corporate guarantee as
authorized by the Board of Directors' resolution. NOTES
As per Sec 128 of the Contract Act,1872, the surety's liability is co-extensive
with that of the principal debtor. For example, Bank MNC has sanctioned a term
loan of Rs 10 lakhs to P on the personal guarantees of Q and S. In this case Bank
MNC is the creditor. P is the borrower or the principal debtor. Both Q&S are the
sureties or guarantors. In case P commits a default, in repaying the debt to the
Bank MNC ( as per the terms and conditions of bank's sanction letter) then both
Q&S (as sureties/guarantors) are liable to pay the dues to the bank.
(2) Guarantees issued by the Bank:
A Bank Guarantee is a commitment given by a banker to a third party,
assuring her/ him to honour the claim against the guarantee in the event of the non-
performance by the bank's customer. A Bank Guarantee is a legal contract which
can be imposed by law. The banker as guarantor assures the third party (beneficiary)
to pay him a certain sum of money on behalf of his customer, in case the customer
fails to fulfill his commitment to the beneficiary.

3.12 Key Concepts

"A contract by which one party promises to save the other form loss caused
to him by the conduct of the promisor himself or by the conduct of any other
person is called a contract of indemnity."
Bank guarantee is a guarantee given by a bank to a third person, to pay
him a certain sum on behalf of the bank's customer, on the customer failing to fulfill
any contractual or legal obligations towards a third person.

3.13 Summary
l One of the important aspects of credit management is to ensure that the
bank is holding all required legal documents.
l Valid legal documents would help the bank to initiate legal course of action
against the defaulter/s.
l Legal documents like hypothecation agreement, deed of pledge, mortgage
deed gives the bank the right of charge over the securities.
l Therefore, it is important that necessary care is taken by the branch manager/
credit officers and others responsible for handling documentation are fully
aware of the bank's requirements in obtaining not only the required documents,
but also all these documents are stamped/executed properly to enable the
banks to recover the loan dues through legal action.
l A contract by which one party promises to save the other from loss caused
to him by the conduct of the promisor himself, or by the conduct of any other
person, is called a 'Contract of Indemnity A contract of guarantee is covered
under the Indian Contract Act,1872.
l Sec 126 defines a guarantee as contract to perform the promise or discharge
a liability of a third person in case of his default. In case the old/sick/
incapacitated account holder can put his thumb or toe impression, the same
may be accepted for withdrawal of money. Banking Laws and
Operations - I (49)
Banking Laws and
Operations - I 3.14 Exercise
Fill in the blanks
1. "A contract by which one party promises to save the other form loss caused
NOTES
to him by the conduct of the promisor himself or by the conduct of any other
person is called a ___________."
(contract of indemnity, contract of guarantee, contract of promise)
2. A contract of indemnity is a class of __________ contracts.
(contingent, fixed, known)
3. The definition of ________________ includes cases where the loss is
caused by the conduct of the promisor himself or by the conduct of any other
Person.
(contract of indemnity, contract of guarantee, contract of promise)
4. The definition of ________________ does not include cases where loss
arises from accidents and events not depending on the conduct of the promisor
or any other person.
(contract of indemnity, contract of guarantee, contract of promise)
5. In an indemnity, the risk is ____________whereas in a guarantee the liability
is subsisting.
(contingent, fixed, known)
6. The rights of indemnity holder are subject to the condition that he does not
contravene the specific directions of the _____________.
(promisee, promisor, suriety)
7. If the indemnity holder acts within the scope of his _________, then he is
entitled to recover from the indemnifier all the sums that he may have paid
pursuant to a compromise in a suit.
(obligation, term, authority)
8. ________________ is a guarantee given by a bank to a third person, to
pay him a certain sum on behalf of the bank's customer, on the customer
failing to fulfill any contractual or legal obligations towards a third person.
(bank promise, bank assurance, bank guarantee)
9. _________ guarantee is the guarantee issued by banks on behalf of its
customers whereby the bank assures a third party that the customer will
perform the contract as per the condition stipulated in the contract, failing
which the bank will compensate the third party to the extent of amount
specified in the guarantee.
(deferred payment, performance, financial)
10. A ____________ guarantee constitutes an undertaking on the part of the
bank to make payment of deferred installments to the seller (beneficiary) on
due dates in the event of default by the customer (buyer).
(deferred payment, performance, financial)
[ANS: 1) contract of indemnity 2)contingent 3) contract of indemnity 4) contract of indemnity
5)contingent 6)promisor 7)authority 8)bank guarantee 9)performance 10)deferred payment]

3.15 Further Readings & References

1. M.L.Tannan, revised by : Banking Law and Practice, Wadhwa & Company,
Nagpur C.R. Datta & S.K. Kataria
2. A.B. Srivastava and : Seth's Banking Law, Law Publisher's India (P) Limited
K. Elumalai
3. R.K. Gupta : BANKING Law and Practice in 3 Vols. Modern Law Publications.
4. Prof. Clifford Gomez : Banking and Finance - Theory, Law and Practice, PHI
Learning Private Limited
Banking Laws and 5. J.M. Holden : The Law and Practice of Banking, Universal Law Publishing.
(50) Operations - I
 Legal Aspects of Banking
UNIT 4 Operations (Accounts)
LEGAL ASPECTS OF BANKING
OPERATIONS NOTES
3. Accounts
Structure
4.0 Introduction
4.1 Objectives
4.2 Deposit Accounts and Complaints Of Customers
4.2.1 Savings bank account
4.2.3 Term Deposit Account
4.2.4 Current Accounts
4.3 Complaints
4.4 Sick/old/incapacitated account holders - Operational Procedure
4.5 Customer Confidentiality Obligations
4.6 Deceased Depositors - Settlement Of Claims - Procedure Thereof
4.6.1 Accounts with survivor/nominee clause
4.6.2 Accounts without the survivor/nominee clause
4.6.3 Access to Safe Deposit Locker/Safe Custody articles
(with survivor/nominee clause)
4.6.4 Access to Safe Deposit Locker/Safe Custody articles
(without survivor/nominee clause)
4.7 Settlement of claims in respect of missing persons
4.8 Unclaimed deposits/Inoperative Accounts in banks
4.9 General Aspects
4.10 Banking Hours/Working Hours/Operation
4.11 Declaration of Holiday under the Negotiable Instruments Act, 1881
4.12 Miscellaneous
4.13 Key Concepts
4.14 Summary
4.15 Exercise
4.16 Further Readings & References

4.0 Introduction
Banks maintain operating accounts like Savings Bank, Current, Overdraft
and Cash Credit accounts which are operated by the cheques drawn by the account
holders on their bankers. While handling these cheques, a banker may act as a
paying banker (when cheques are drawn on him) or collecting banker (when cheques
are deposited with him). Banks are under statutory obligation to honour a cheque
and make payment if it is in order as per relevant laws. As a collecting banker, he
should collect the cheques only for his customer and as per the provisions of the
legal frame work the Negotiable Instruments Act,1884. Legal aspects in banking
operations such as indemnities and guarantees are important in banker's point of
Banking Laws and
view.
Operations - I (51)
Banking Laws and
Operations - I 4.1 Objectives
After reading this unit, you should be able to:
- To understand the important aspects of the role of a banker as paying and
NOTES
collecting banker
- To know about the legal aspects of banking operations and the precautions
taken by banks
- To understand the legal aspect of Indemnities and Guarantees C- OPERA-
TIONS IN

4.2 Deposit Accounts and Complaints of Customers

RBI has issued certain guidelines for banking operations and redressal of
customer complaints. These guidelines have been summarized below:
CHECK YOUR
PROGRESS
4.2.1 Savings Bank Account
These deposits accounts are one of the most popular deposits for individual
Describe types of accounts. These accounts not only provide cheque facility but also have lot of
bank accounts? flexibility for deposits and withdrawal of funds from the account. Most of the
banks have rules for the maximum number of withdrawals in a period and the
maximum amount of withdrawal, but hardly any bank enforces these. However,
banks have every right to enforce such restrictions if it is felt that the account is
being misused as a current account.
- The Savings Bank Rules must be made available to account holders while
opening the accounts.
- Photographs of all depositors/account holders whether resident or non-resident
should be obtained in respect of all types of deposit accounts including fixed,
recurring, cumulative, etc. except:-
(i) Banks, Local Authorities and Govt. Departments (excl. public sector
undertakings or quasi Government bodies);
(ii) Accounts of Staff members (single/joint)
- Banks need not insist for the presence of account holder for making cash
withdrawal of 'self' or bearer cheques unless circumstance so warrants.
- Photographs cannot be a substitute for specimen signatures.
- Only one set of photographs need be obtained and separate photographs
need not be obtained for each category of deposit.
- Photographs of the ' Pardanishin' women need to be obtained
- For additional accounts, fresh photographs need not be insisted upon.
- While opening the accounts, the account holders should be informed in
transparent manner the requirement of minimum balance and other charges,
etc. Revision in charges also needs to be advised from to time.
- Banks may purchase cheques, drafts, etc. deposited in the account for clearing
in case of suspension of clearing operations temporally or apprehension of
prolonging the suspension. This facility is extended to customers upon
examining the credit worthiness, integrity, past dealing, occupation, etc. so as
to guard themselves from the possibilities of such instrument being dishonored
subsequently.
Banking Laws and
(52) Operations - I
- Savings Bank Pass Books must be provided invariably to all customers. In Legal Aspects of Banking
case of account statement, the same should be mailed to the customers Operations (Accounts)
regularly. These facilities should be provided at Bank's cost.
Updating the pass book periodically should also be arranged by the banks.
NOTES
- Banks may avoid the usage of inscrutable entries in pass books/statement of
account and ensure that brief, intelligible particulars are invariably entered in
pass books / statement of account with a view to avoiding inconvenience to
depositors.
- Banks are required to ensure that full address / telephone number of the
branch is invariably mentioned in the Pass Books / Statement of Accounts
issued to account holders.
- All cheque forms should be printed in Hindi and English irrespective of the
language the customer uses including regional language.
- Cheques bearing date in Hindi as per the National Calendar (Saka Samvat)
can be accepted by banks for payment, if otherwise in order. Banks can,
however, ascertain the Gregorian calendar date corresponding to the National
Saka calendar in order to avoid payment of stale cheques.
- Banks are required to make available the Magnetic Ink Character Recognition
(MICR) code and Indian Financial System Code (IFSC), besides cheque
leaf, in all passbook/ statement of account holders

4.2.3 Term Deposit Account

All Banks in India offer fixed deposits schemes with a wide range of
tenures for periods from 7 days to 10 years. These are also popularly known as
FD accounts. However, in some other countries these are known as "Term
Deposits" or even called "Bond".

- Banks are required to issue term deposit receipt indicating therein full details,
such as, date of issue, period of deposit, due date, applicable rate of interest,
etc.
- Term Deposit Receipts can be freely transferable from one office of bank to
another.
- In order to extend better service, banks should ensure sending of intimation
of impending due date of maturity well in advance to their depositors. Change
in rate of interest should be advised well in advance to the customers.
- Deposits repayable in less than three months or where the terminal quarter
is incomplete, interest should be paid proportionately for the actual number
of days reckoning the year at 365 days or 366 days in case of leap year.
- Banks may allow premature withdrawal of Term Deposits at the request of
the depositor and interest on the deposit for the period that it has remained
with the bank will be paid at the rate applicable Banks have the freedom to
fix penal interest on such withdrawal. No interest need be paid where
premature withdrawal takes place before completion of the minimum period
prescribed.
- Bank can permit addition/deletion of name/s of joint account holders. However,
the period and aggregate amount of the deposit should not undergo any change.
Banks may also allow splitting of joint deposit, in the name of each of the
Banking Laws and
joint account holders provided that the period and the aggregate amount of
Operations - I (53)
Banking Laws and the deposit do not undergo any change.
Operations - I
- Banks may renew the frozen accounts upon obtaining suitable request letter
for renewal. No renewal receipt be issued but suitable noting may be done in
the deposit account. Renewal of the deposit may be advised to the concerned
NOTES Enforcement Authority by registered post/Speed Post/Courier. Overdue
interest may be paid as per the policy adopted by the banks.
- Banks are required to ensure that their branches invariably accept cash over
the counters from all their customers who desire to deposit cash at the
counters. No product can be designed which is not in tune with the basic
tenets of banking i.e. acceptance of cash.
- Notwithstanding the legal provisions, opening of fixed/recurring and savings
bank accounts be permitted in the name of minor with mother as guardian
provided bank take adequate safeguards in allowing operations in the accounts
by ensuring that such accounts are not allowed to be overdrawn and that
they always remain in credit.

CHECK YOUR
PROGRESS 4.2.4 Current Accounts
- Current Accounts are basically meant for businessmen and are never used
Describe procedure of for the purpose of investment or savings. These deposits are the most liquid
complaints? deposits and there are no limits for number of transactions or the amount of
transactions in a day. Most of the current account are opened in the names
of firm / company accounts. Cheque book facility is provided and the account
holder can deposit all types of the cheques and drafts in their name or endorsed
in their favour by third parties. No interest is paid by banks on these accounts.
On the other hand, banks charges certain service charges, on such accounts.
- Banks while opening current account must obtain a declaration to the effect
that the account holder is not enjoying any credit facilities with any other
bank. Banks must scrupulously ensure that their branches do not open current
accounts of entities which enjoy credit facilities (fund based or non- fund
based) from the banking system without specifically obtaining a No-Objection
Certificate from the lending bank(s).
- Bank may open account of prospective customer in case no response is
received from its existing bankers upon waiting for a fortnight. The situation
may be reviewed with reference to the information provided by the prospective
customer as well as taking needed due diligence on the customer.
- For corporate entities enjoying credit facilities from more than one bank, the
banks should exercise due diligence and inform the consortium leader, if
under consortium, and the concerned banks, if under multiple banking
arrangement.

4.3 Complaints
- Banks are required to provide Complaints/suggestion box at each office besides
maintaining Complaint
Book/Register with perforated copies in each set. A copy of the complaint is
also to be forwarded to Controlling Office along with remark of the Branch
Manager within a time frame.
Banking Laws and - Complaint form along with name of the nodal officer for complaint redressal
(54) Operations - I
 be provided in the Homepage of Website to facilitate submission by customers. Legal Aspects of Banking
Complaints received are to be reviewed by Board for taking corrective steps Operations (Accounts)
wherever required. The details are to be disclosed in the financial results
giving the number of complaints received, redressed, Awards by Ombudsman,
etc. NOTES
- Banks are also required to put in place a proper Grievance Redressal
Mechanism and examine on an ongoing basis whether it is found effective in
achieving improvement in customer service in different areas.

4.4 Sick/old/incapacitated account holders -

Operational Procedure
In case the old/sick/ incapacitated account holder can put his thumb or toe
impression, the same may be accepted for withdrawal of money. It should be
identified by two independent witnesses known to the bank, one of whom should
be a responsible bank official.
- Where the customer cannot put even his/her thumb impression and also not
able to present in the bank, a mark can be obtained on the cheque/withdrawal
form which should be identified by two independent witnesses, one of whom
should be a responsible bank official.
- Person to whom the payment is to be made may be indicated by the customer
in both the above cases and he should be identified by two independent
witnesses. The person should be asked to furnish his signature to the bank.
- As per the opinion obtained by IBA, a toe impression or any mark by a
customer who lost both the hands can be taken for acceptance.
- Banks are required to take necessary steps to provide all existing ATMs /
future ATMs with ramps so that wheel chair users / persons with disabilities
can easily access them and also make arrangements in such a way that the
height of the ATM does not create an impediment in its use by a wheelchair
user.
- Banks are required to ensure that all the banking facilities such as cheque
book facility including third party cheques, ATM facility, Net banking facility,
locker facility, retail loans, credit cards etc., are invariably offered to the
visually challenged without any discrimination.
- Banks are required to make at least one third of new ATMs installed as
talking ATMs with Braille keypads and place them strategically in consultation
with other banks to ensure that at least one talking ATM with Braille keypad
is generally available in each locality for catering to needs of visually impaired
persons.
- In respect of disabled persons with autism, cerebral palsy, mental retardation
and multiple disabilities
Banks can rely upon the Guardianship Certificate issued either by the
District Court under Mental Health
Act or by the Local Level Committees under the above Act for the purposes
of opening / operating ban accounts.

Banking Laws and

Operations - I (55)
Banking Laws and
Operations - I 4.5 Customer Confidentiality Obligations
Banks are not supposed to divulge any information about the account to third parties
except where:-
NOTES
(a) disclosure is under compulsion of law
(b) there is duty to the public to disclose
(c) interest of bank requires disclosure and
(d) the disclosure is made with the express or implied consent of the
customer.
The information collected from the customer for the purpose of opening of
account is to be treated as confidential and not divulge any details thereof for cross
selling or any other purposes.
Transfer of account from one branch to another Instructions from customer for
transfer of his account to another office should be carried out immediately by
transferring the account opening form, specimen signature, standing instructions,
CHECK YOUR
etc. under advice to the customer.
PROGRESS

Describe Customer
Confidentiality 4.6 Deceased Depositors - Settlement of Claims -
Obligations?
Procedure Thereof
4.6.1 Accounts with survivor/nominee clause
In case there exists a valid nomination and the deposit account is opened
with the survivorship clause ("either or survivor" or "anyone or survivor" or "former
or survivor" or "latter or survivor"), bank can make payment of the balance in the
deposit account to the survivor(s)/nominee of a deceased deposit account holder
which is considered as a valid discharge of the bank's liability provided:-
a) The bank has exercised due care and caution in establishing the identity
of the survivor(s)/ nominee and fact of death of the account holder through
appropriate documentary evidence; there is no order from the competent court
restraining the bank from making the payment from the account of the deceased;
and
(b) Survivor(s)/nominee has been advised in clear terms that he would be
receiving the payment from the bank as a trustee of the legal heirs of the deceased
depositor.
Banks may desist from insisting production of succession certificate, letter
of administration or probate, etc., or obtain any bond of indemnity or surety from
the survivor(s)/nominee, irrespective of the amount standing to the credit of the
deceased account holder.

4.6.2 Accounts without the survivor/nominee clause

- In deceased deposit accounts without the survivor/nominee clause, banks
may fix some minimum threshold limit for settlement of claim without insisting
on production of any documents other than indemnity.
- Premature termination of Term deposit accounts would not attract any penalty
and such clause may be incorporated in the opening form itself.
Banking Laws and - Any claim on the balances lying in deceased depositors received from
(56) Operations - I
 survivor(s) / nominee(s) should be settled within a period not exceeding 15 Legal Aspects of Banking
days from the date of receipt of the claim subject to the production of proof Operations (Accounts)
of death of the depositor and suitable identification of the claim(s), to the
bank's satisfaction.
NOTES
4.6.3 Access to Safe Deposit Locker/Safe Custody articles
(with survivor/nominee clause)
- In the event of death of sole locker hirer, banks may give access to the
locker with liberty to remove the contents of the locker to the nominee and in
case of the locker hired jointly with operational instruction to operate under
joint signatures and nomination exists, bank may give access to the locker
with liberty to remove the articles jointly to the survivor(s)/nominee.
- In the case of the locker was hired jointly with survivorship clause and the
hirers instructed that the access of the locker should be given over to "either
or survivor", "anyone or survivor" or "former or survivor" or according to any
CHECK YOUR
other survivorship clause, banks may follow the mandate in the event of the
PROGRESS
death of one or more of the locker-hirers.
Describe Settlement
4.6.4 Access to Safe Deposit Locker/Safe Custody articles of claims in respect of
missing persons?
(without survivor/nominee clause)
- Banks are required to evolve a customer-friendly procedure drawn up in
consultation with their legal advisers for giving access to legal heir(s) / legal
representative of the deceased locker hirer. Similar procedure should be
followed for the articles under safe custody of the bank.
- Banks are also required to prepare an inventory before returning articles left
in safe custody/before permitting removal of the contents of the safe deposit
locker. Banks are not required to open sealed/ closed packets left with them
in Safe Custody or found in locker while releasing them to the nominee and
surviving locker heirs/depositor of safe custody article. Banks are required
to put in their website the entire procedure for improvement in customer
service.

4.7 Settlement of claims in respect of missing persons

Banks are required to formulate a policy which would enable them to
settle the claims of a missing person after considering the legal opinion and taking
into account the facts and circumstances of each case (claims are to be settled as
per provisions u/s 107/108 of Indian Evidence Act 1872).
In order to avoid inconvenience and undue hardship to the common person,
banks may, keeping in view their risk management systems, fix a threshold limit, up
to which claims in respect of missing persons could be settled without insisting on
production of any documentation other than (i) FIR and the non-traceable report
issued by police authorities and (ii) letter of indemnity.

4.8 Unclaimed deposits/Inoperative Accounts in banks

- A savings as well as current account should be treated as inoperative / dormant
if there are no transactions in the account for over a period of two years. Banking Laws and
Operations - I (57)
Banking Laws and - If credits by way of interest on Fixed Deposit account is being received in
Operations - I the Savings Bank accounts as per the mandate of the customer, the same
can be treated as a customer induced transaction and the account can be
treated as an operative account. It will become inoperative only after 2 years
NOTES from the date of the last credit entry of the interest on Fixed Deposit account.
- Banks need to ascertain the whereabouts of the account holder(s) by letters,
telephone calls, or contacting legal heirs, or contacting the introducers or
employers as available record or any other means suited to them in case of
no operations (credits other than periodic interest or debiting service charges)
for more than one year.
- Periodical interest should continue to be credited in the inoperative accounts
and proceeds of FDR unpaid, the amount left unclaimed should attract Savings
Bank rate of interest. Inoperative accounts should get audited periodically.
There should not be any charge on activation of an inoperative account.

4.9 General Aspects

(a) Reconciliation of transactions at ATMs failure
- Banks are required to resolve complaints within 7 working days from the
date of receipt of the complaint.
- Failure to re-credit the amount with the timeframe should entail payment of
compensation to the customer @100/- per day by the issuing bank.
- For compensation, suitable application is to be made within 30 days of date
of the transaction.
- All disputes regarding ATM failed transactions should be settled by the issuing
bank and the acquiring bank through the ATM System Provider only. No
bilateral settlement arrangement outside the dispute resolution mechanism
available with the system provider is permissible.
- Non-adherence to the provision attract penalty under the Payment and
Settlement System Act 2007.
- Banks are required to display prominently at the ATM locations that complaints
should be lodged at the branches where customers maintain accounts to
which the ATM is linked along with telephone numbers of help desk/contact
persons of ATM owning bank, etc.
- Each bank should ensure that the process flow is modified to provide for the
pin validation for every transaction including balance enquiry facilitated through
ATM. Failure to this attract penalty.
- Banks are required to have in place a system of online alerts for all types of
transactions irrespective of the amount involving usage of cards at various
channels.

(b) Levy of Service Charges

Banks should ensure that the service charges fixed are reasonable and
they are not out of line with the cost of providing such services. Customers with
low volume of transactions are not penalized.

(c) Foreclosure charges/prepayment penalty - Home Loans

Banking Laws and
Banks are not permitted to levy/charge prepayment charges/penalties on
(58) Operations - I
Home Loans on floating interest rates, with immediate effect. Legal Aspects of Banking
Operations (Accounts)

(d) Remittance
- Remittance (DD/MT/TT, etc.) of Rs. 50000/- and above should be by debit NOTES
to customer's account or against cheques only. DDs of Rs. 20,000/- and
above are to be issued with "Account Payee" crossing only.
- A DD is uniformly valid for a period of three months and procedure for
revalidation after three months should be simplified.
- Duplicate Draft in lieu of lost for amount up to and including Rs. 5000/- can
be issued against suitable indemnity without waiting drawing advice within a
fortnight from the date of receipt of the request. Delay beyond the period,
penal provision to be invoked.
- Banks may ensure that both drop box facility and the facility for
acknowledgement of cheques are made available at collection centres
(branches) and no branch should refuse to give acknowledge of cheques if CHECK YOUR
tendered at the counters. Banks should display on the drop box itself that PROGRESS
"Customers can also tender the cheques at the counter and obtain
acknowledgement on the pay-in-slips". Describe banking
- Banks may place per transaction limits based on their risk perception in hours?
respect of Mobile transactions with the approval of their respective Boards.
- Banks need not make payment of cheques/drafts/pay orders/ banker's
cheques bearing that date or any subsequent date, if they are presented
beyond the period of three months from the date of such instrument (w.e.f.
04.04.12)
- For loss of cheque in transit or in clearing process or at the paying bank's
branch, the banks are required to reimburse the accountholder related
expenses for obtaining duplicate instruments and also interest for reasonable
delays occurred in obtaining the same. The onus rests with the collecting
banker and not the account holder.

(e) Co-ordination with officers of Central Board of Direct Taxes

Banks should maintain greater co-ordination between the Income-Tax
department and extend necessary help/coordination to tax officials whenever
required.

4.10 Banking Hours/Working Hours/Operation

- Banks are required to function for public transactions at least for 4 hours on
week days and 2 hours on Saturdays in the larger interest of public and
trading community. Extension counters, satellite offices, one man offices or
other special class of branches may remain open for such shorter hours as
may be considered necessary.
- Banks may fix, after due notice to customers, whatever business hours are
convenient i.e. double shift, weekly holiday other than Sunday, or functioning
Sundays also (7 days working) etc.
- The banks' branches in rural areas can fix the business hours (i.e., number
of hours, as well as timings) and the weekly holidays to suit local requirements
Banking Laws and
subject to the guidelines. Operations - I (59)
Banking Laws and - Commencement of employees' working hours 15 minutes before
Operations - I commencement of business hours could be made operative by banks at
branches in metropolitan and urban centres.
- Banks are required to extend business hours for banking transactions other
NOTES than cash till one hour before close of working hours. Banks can have evening
counters at the premises of existing branches in metropolitan/ urban centres
for providing facilities to the public beyond normal business hours to bring
about improvement in customer service and the transactions should be merged
with the main accounts of the branch where it is set up.
- All branches except very small branches should have "Enquiry" or "May I
help You" counters either exclusively or combined with other duties located
near the entry point of the banking hall. Time norms should also be displayed
prominently in the banking hall.
- All Branch branches are required to display the various products and services
they provide along with various key aspects such as service charges, interest
rates, time norms for various banking transactions and grievance redressal
CHECK YOUR
mechanism, etc. grouped in 4 heads viz. "Customer Service Information",
PROGRESS
"Service Charges", "Grievance redressal" and "Others" as indicators in the
Notice Boards as per the format provided by RBI. This would enhance the
Describe Declaration
quality of customer service in banks and level of customer satisfaction.
of Holiday under the
N e g o t i a b l e - Further, in addition to the above Board, the banks should also display details
Instruments Act, such as 'Name of the bank / branch, Working Days, Working Hours and
Weekly Off-days' outside the branch premises.
1881?
- Banks are further required to make available the detailed information in their
Web-site in such a manner that customers are able to easily access the same
from the Home Page of the site, besides in booklet form in the touch screen
by placing them in the information kiosks or Scroll Bars, or Tag Boards.
Website should contain the minimum information such as Policy/Guidelines,
Complaints, Opening of accounts/ forms, Loans and Advances, Branches,
etc.

4.11 Declaration of Holiday under the Negotiable

Instruments Act, 1881
- In terms of Section 25 of the Negotiable Instruments Act, 1881, the expression
"public holiday" includes Sunday and any other day declared by the Central
Government by notification in the Official Gazette to be a public holiday.
- This power has been delegated to State Govt. by Central Govt. subject to the
condition that the Central Government may itself exercise the said function,
should it deem fit to do so and this implies that when Central Government
itself has notified a day as "public holiday" under Section 25 of the Negotiable
Instruments Act, 1881, there is no need for banks to wait for the State
Government notification.

4.12 Miscellaneous
- In predominantly residential areas banks may keep their branches open for
business on Sundays by suitably adjusting the holidays and banks should
Banking Laws and
keep rural branches open on weekly market day.
(60) Operations - I
- Banks are required to accept standing instructions in Savings and Current Legal Aspects of Banking
accounts and the same can be enlarged to include payments on account of Operations (Accounts)
taxes, bills, rents, school/college fees, etc.
- Branch Manger may be permitted to allow clean overdraft for small amounts
to customers whose dealings have been satisfactory. NOTES

- All transactions, including payment of interest on deposits/charging of interest

on advances, should be rounded off to the nearest rupee
- In order to keep a watch on the progress achieved by the bank in the
implementation of the recommendations of various working groups/
Committees on customer service, banks may examine the recommendations
which have relevance in the present day banking and continue to implement
them.
- Banks should follow various provisions of the Code of Bank's Commitment
to Customers, implementation of which is monitored by the Banking Codes
and Standards Board of India (BCSBI), etc.

4.13 Key Concepts

l Saving bank accounts are one of the most popular deposits for individual
accounts. These accounts not only provide cheque facility but also have lot
of flexibility for deposits and withdrawal of funds from the account.
l Current Accounts are basically meant for businessmen and are never used
for the purpose of investment or savings. These deposits are the most liquid
deposits and there are no limits for number of transactions or the amount of
transactions in a day.
l All Banks in India offer fixed deposits schemes with a wide range of tenures
for periods from 7 days to 10 years. These are also popularly known as FD
accounts. However, in some other countries these are known as "Term
Deposits" or even called "Bond".

4.14 Summary
l Sec 126 defines a guarantee as contract to perform the promise or discharge
a liability of a third person in case of his default. In case the old/sick/
incapacitated account holder can put his thumb or toe impression, the same
may be accepted for withdrawal of money.
l Photographs of all depositors/account holders whether resident or non-resident
should be obtained in respect of all types of deposit accounts including fixed,
recurring, cumulative, etc.
l All cheque forms should be printed in Hindi and English irrespective of the
language the customer uses including regional language.
l Banks are required to issue term deposit receipt indicating therein full details,
such as, date of issue, period of deposit, due date, applicable rate of interest,
etc.
l Term Deposit Receipts can be freely transferable from one office of bank to
another.
l Bank may open account of prospective customer in case no response is Banking Laws and
Operations - I (61)
Banking Laws and received from its existing bankers upon waiting for a fortnight. The situation
Operations - I may be reviewed with reference to the information provided by the prospective
customer as well as taking needed due diligence on the customer.
l In case the old/sick/ incapacitated account holder can put his thumb or toe
NOTES impression, the same may be accepted for withdrawal of money.
l In case of reconciliation of transactions of ATMs failure Banks are required
to resolve complaints within 7 working days from the date of receipt of the
complaint.
l A DD is uniformly valid for a period of three months and procedure for
revalidation after three months should be simplified.
l Banks are required to function for public transactions at least for 4 hours on
week days and 2 hours on Saturdays in the larger interest of public and
trading community.

4.15 Exercise
Fill in the blanks
1. Photographs of the '__________' women need to be obtained.
(Pardanashin, Old, Widow)
2. ___________ cannot be a substitute for specimen signatures.
(Photographs, Identity Card, Passport)
3. MICR code stands for_________________.
(Magnetic Identity Character Recognition, Magnetic Ink Character
Recognition, Magnetic India Character Recognition)
4. IFSC stands for _________________.
(Indian Fiscal System Code, Indian Final System Code, Indian Financial
System Code)
5. ______ Deposit Receipts can be freely transferable from one office of
bank to another.
(Current, Fixed, Term)
6. A copy of the complaint is to be forwarded to Controlling Office along with
remark of the _________ within a time frame.
(Branch Manager, Account Holder, Cashier)
7. In case the old/sick/ incapacitated account holder, his thumb or toe impression,
should be identified by _______independent witnesses known to the bank,
one of whom should be a responsible bank official.
(two, one, three)
8. Banks are not supposed to divulge any information about the account to third
parties except where disclosure is under compulsion of _________.
(Law, Bank rules, Branch manager)
9. Banks are required to evolve a customer-friendly procedure drawn up in
consultation with their legal advisers for giving access to _________ / legal
representative of the deceased locker hirer.
(Legal heir(s), Relatives, Friends)
10. A savings as well as current account should be treated as inoperative / dormant
if there are no transactions in the account for over a period of ________.
Banking Laws and (Two years, Three years, One year)
(62) Operations - I
11. Reconciliation of transactions at ATMs failure compensation, suitable Legal Aspects of Banking
application is to be made within _______ of date of the transaction. Operations (Accounts)
(15 days, 20 days, 30 days)

NOTES
[ANS: 1)Pardanashin 2)Photographs 3) Magnetic Ink Character
Recognition 4) Indian Fiscal System Code 5) Term, 6) Branch manager, 7)
Two 8) Law, 9) Legal heir(s), 10) Two years, 11) 30 days.]

4.16 Further Readings & References

1. M.L.Tannan, revised by : Banking Law and Practice, Wadhwa & Company,
Nagpur C.R. Datta & S.K. Kataria
2. A.B. Srivastava and : Seth's Banking Law, Law Publisher's India (P) Limited
K. Elumalai
3. R.K. Gupta : BANKING Law and Practice in 3 Vols. Modern Law Publications.
4. Prof. Clifford Gomez : Banking and Finance - Theory, Law and Practice, PHI
Learning Private Limited
5. J.M. Holden : The Law and Practice of Banking, Universal Law Publishing.

Banking Laws and

Operations - I (63)
Banking Laws and
Operations - I UNIT 5
TYPES OF SECURITIES IN BANKS
NOTES Structure
5.0 Introduction
5.1 Objectives
5.2 Land/Real Estate as a Security for the Loan/Advance
5.3 Stocks and Shares as a Security for the Loan/Advance
5.4 Debentures as a Security for the Loan/Advance
5.5 Goods as a Security for the Loan/Advance
5.6 Life Policies as a Security for the Loan/Advance
5.7 Book Debts as a Security for the Loan/Advance
5.8 Fixed Deposit as a Security for the Loan/Advance
CHECK YOUR 5.9 Supply Bills as a Security for the Loan/Advance
PROGRESS 5.10 Key concepts
5.11 Summary
Describe Land/Real 5.12 Exercise
Estate as a Security 5.13 Further Readings & References
for the Loan/
Advance?
5.0 Introduction
Banks are required to be careful in handling various loans and advances,
otherwise banks may be exposed to various risks. Non observance of proper controls,
monitoring, and checking might result in the bank's financial loss and sometimes
even affects the reputation as well. In this regard understanding the importance of
legal terms i.e., Charges like lien, set off, mortgage, pledge, hypothecation and
assignment are important. Banks lend money to the borrowers against various
kinds of securities. Banks should ensure that they obtain securities to protect the
bank in case of default by the borrower. To protect the interests of the banks, the
securities obtained by banks should have marketable value and also such security
can be legally enforceable.

5.1 Objectives
After reading this unit, you should be able to:
- understand the importance of securities in bank's loans and advances
- differentiate between various types of securities

5.2 Land/Real Estate as a Security for the Loan/Advance

Bankers in the olden days were very much averse to accept land and
building as a security, but this prejudice has over a period of time changed and land
and building as a security has become an acceptable collateral in most advances,
more particularly to corporate customers. The advantages and disadvantages of
this form of security cannot be universally applied to all lands and it depends on the
nature of the land offered. We shall now discuss both the advantages and
Banking Laws and disadvantages.
(64) Operations - I
Advantages Types of Securities
(i) The advantage that land has over other types of securities is that its in Banks
value generally increases with time. With every fall in the value of money, the
value of land goes up and due to its scant availability in developing areas its value
is bound to increase. NOTES
(ii) It cannot be shifted, a fact which sometimes is also a disadvantage.

Disadvantages
(i) Valuation is at times difficult
The value of a building depends on several factors such as location, size of
property, state of repair, amenities, etc., and in the case of factories and industrial
buildings, the machinery, nature of industry, etc. This makes the valuation very
difficult. Buildings and the materials used in the buildings are not alike. In fact,
buildings must be valued on a conservative basis because of limited market in the
event of sale.
(ii) Ascertaining the title of the owner
The banker cannot obtain a proper title unless the borrower himself has
title to the property to be mortgaged. In India, the laws of succession particularly
those relating to Hindus and Muslims being very complicated, it is difficult to ascertain
whether a person has a perfect title to the property or not. The banker would
therefore have to consult solicitors and obtain their opinion before accepting it as a
security, which in many cases delays lending. Title verification, must also be done
to know whether the property was encumbered. This has to be done by verifying
record with the Registrar's office, which involves expense and time. In the case of
agricultural land, with the introduction of land ceiling legislation, legislation protecting
the tenants' rights, absence of up-to-date and proper land records, it has become
less valuable as a security. Added to this there have been a number of legislations
in different states giving debt relief to the farmers and prohibiting transfer of land
to persons other than agriculturist.
(iii) Difficult to realize the security
Land is not easily and quickly realizable, due to the lack of ready market. It may
take months to sell and sometimes if the market is not favourable, it may fetch a
lower price than what was anticipated.
(iv) Creating a charge is costly
The security can be charged either by way of legal mortgage or by way of
an equitable mortgage. An equitable mortgage may be created by a simple deposit
of title deeds with or without a memorandum. Although equitable mortgage is less
expensive, a banker always prefers legal mortgage to an equitable mortgage. Since
the remedies under a legal mortgage are better than those under an equitable
mortgage. However, completing a legal mortgage involves expenses including stamp
duty and lot of formalities.
(v) Difficulty on account of Rent Control Act
In the case of buildings, which come within the purview of the Rent Control
Act, it would be difficult to sell the building, particularly when a tenant has been
occupying it for a long time.

Precautions to be taken by the banker

(i) Financial soundness of borrower
The banker should place more reliance on the financial soundness of the
borrower. Banking Laws and
Operations - I (65)
Banking Laws and (ii) Borrower's title
Operations - I
The banker should get a solicitor to verify the title to the property and the
right of the borrower to mortgage.

NOTES
(iii) Enquiry regarding prior charges
The borrower should produce a certificate from the Registrar's office listing
the charges over the property over a period of time (generally 30 years) that the
property is free from encumbrances. This is commonly understood as non-
encumbrance certificate. If any prior charges exist the banker's right will be subject
to such prior charges.

(iv) Freehold or leasehold

A freeholder is the absolute owner of his land and is able to deal with it as
he likes. A leasehold property is one, which is taken on lease for a period and a
leaseholder derives a legal status for a term of years from the freeholder and is
free to deal with the land when acting within the terms of the lease and within the
law during that period. When the lease expires, the land reverts to the freeholder.
In the case of leasehold property, the unexpired period of the lease is an important
consideration. The longer the unexpired period of the lease, greater is the value of
the security. The bank should also ensure that there are no onerous covenants
such as the necessity of taking the freeholder's consent before mortgaging the
property. The banker should also obtain the last ground receipt to ensure that the
lease is active.

(v) Valuation of the property

Valuation can be done in anyone of the following ways:
(a) By utilizing the services of recognized valuers who would be engineers
or architects.
(b) Making enquiries with local real estate agents.
(c) By local authorities.
(d) Latest sale transaction of neighbouring properties.
(e) Calculations based on the annual rental value.

(vi) Registration
Where the principal money secured is ` 100 or more, a mortgage charge is
required to be registered unless the charge is an equitable mortgage.

(vii) Documentations
The mortgage deed must be drafted carefully considering all the legal
stipulations. It should be witnessed by at least two persons In case of simple mortgage
it attracts ad-valorem stamp duty.

(viii) Verification of Tax Receipts

The banker should request the borrower to produce latest tax receipts
since any arrears of tax constitute a preferential charge on property.

(ix) Insurance of the property

To avoid loss of security by fire, natural calamities, it is prudent that in the
case of buildings the banker insist on the insurance of the property for its full value
Banking Laws and
(66) Operations - I at the borrower's expense.
 Types of Securities
5.3 Stocks and Shares as a Security for the Loan/Advance in Banks

Shares
These may be classified into preference shares (which enjoy preference NOTES
both with regards the payment of dividend and repayment of capital) and equity
shares, i.e., shares which are not preference shares.
Advantages
(i) Value of the security can be ascertained without any difficulty.
(ii) In normal times, stocks and shares enjoy stability of value and are not
subject to wide fluctuations.
(iii) Stocks and shares require very little formalities, for taking them as security.
(iv) It is easier compared to real estate to ascertain the title, more so with the
advent of depositories.
(v) Creating a charge of this is less expensive than real estate.
(vi) They yield income by way of dividends, which can be appropriated towards
CHECK YOUR
the loan account.
PROGRESS
(vii) Being a tangible form of securities they are more reliable.
(viii) The release of such securities involves very little expense and formality. Describe Stocks and
Shares as a Security
Disadvantages for the Loan/
(i) Being easy to realize, they are fraud prone and as such they must be Advance?
properly secured.
(ii) In the case of partly paid shares, the following demerits are there:
(a) The banker may have to pay the calls.
(b) Partly paid shares are subject to violent price fluctuations.
(c) They are not easily realizable because of the restricted market for
such shares.

Precautions while taking stocks and shares as security

Banker must take the following precautions while advancing against stocks
and shares:
(i) In the case of partly paid shares
(a) the banker should never register them in his name.
(b) He must ensure that pending calls are paid.
(c) Sufficient margin should be taken to avoid any future loss or change
in the value of the security.
(d) The banker should verify share certificate and ensure that the calls,
are paid properly and entered in the space provided for the same.

Other precautions
(i) Update the list of shares which the particular bank is willing to lend against
on a regular basis.
(ii) Updating the amount that can be lent against a particular share which is
called the card limit at regular intervals
(iii) Yearly review of the portfolio or more frequent review depending upon
the volatility in the capital market.
Banking Laws and
Operations - I (67)
Banking Laws and
Operations - I 5.4 Debentures as a Security for the Loan/Advance
Debenture is a document issued by a company acknowledging its
indebtedness to the bearer or a registered holder. A fixed rate of interest is payable
NOTES
at stated periods on such debentures. In the case of mortgage debentures, a charge
is created on the assets of the company issuing such debentures in favour of a
trustee who is responsible to take care of the interest of individual investors.
Advantages
(i) Easy to sell.
(ii) Not subject to violent price fluctuations.
(iii) They can be transferred at minimum cost.
(iv) Bearer debentures are fully negotiable.
(v) They rank in priority to shares and mostly secured by a charge on the
company's property.

CHECK YOUR
Disadvantages
PROGRESS
(i) If interest is not paid regularly on the debentures it would affect its price
Describe Debentures and marketability.
as a Security for the (ii) If the charge on property of company is not registered, the subsequent
Loan/Advance? charges will get a priority.
(iii) Debentures may be issued by companies having no power to borrow
money.

Precautions to be taken while taking debentures as security

(i) The nature of the debentures must be ascertained, i.e., whether they are
unsecured or secured, the later, being preferred.
(ii) The borrowing powers of the company issuing the debentures must be
ascertained, and to verify that the same has not been exceeded.
(iii) Deposit of the debentures plus a memorandum of deposit is necessary.
(iv) The nature and value of the assets charged must be examined frequently.
(v) The banker must find out whether there are any un-cancelled redeemed
debentures.

5.5 Goods as a Security for the Loan/Advance

Though, earlier, bankers were not forthcoming to advance against goods
or documents of title to goods, now more and more secured advances of the
scheduled banks in India are against goods.
Merits of this Security
(i) Goods have a ready market and as such can be easily sold unlike other
kinds of security
(ii) Valuation of the goods can be easily done.
(iii) The banker gets a tangible form of security compared to unsecured
advances, which in case of default by the borrower, can be realized by
sale of pledged goods.
(iv) Advances against goods are normally given for short periods and therefore
the risk of the banker is considerably reduced.
Banking Laws and
(68) Operations - I
 (v) Barring a few states where the stamp duty is heavy, creating a charge on Types of Securities
the security is less costly and involves minimum formalities. in Banks
(vi) Banker acquires a good title to the goods when dealing with customers of
repute and standing.
NOTES
Demerits of this Security
(i) Certain goods are liable to perish or deteriorate in quality over a period of
time, thus resulting in reduction of the value of the banker's security.
(ii) There are possible risks of fraud or dishonesty on the part of the borrower.
For example, when 10,000 tins of cashew nuts are shown in the godown
as security for an advance, it is not possible for the banker to verify the
quality and quantity in every tin. It is not even possible to verify whether
all the 10,000 tins contain cashew nuts. A fraudulent borrower may not
store the full stocks as declared in the godown.
(iii) The value of the security in certain cases more particularly electronic
consumer goods are subject to wide fluctuations. Therefore, the valuation
of such goods is difficult. Even in the case of necessaries, there being
several varieties, unless the banker has expert knowledge, the valuation
may be misleading. Disposing of large quantities of goods within a short
time may be difficult and may not fetch the expected/ declared price.
(iv) The banker may find it difficult to store the goods.
(v) Transporting the goods from the borrower's premises to the banker's
premises and thereafter to the market in case of sale is a considerably
costly and time-consuming affair.
(vi) When the banker releases goods for sale on the execution of trust receipts,
the money realized by the sale of such goods may not be deposited with
the banker, and the borrowers may default to the bankers.
(vii) If the goods are warehoused, the warehouse keeper enjoys a lien over
the goods for any unpaid charges. The banker therefore, has to ensure
periodically that all charges are duly paid.

Valuation of Goods
(i) Advances are given based on the stocks and their value declared in monthly
stock/statements. The stock/ goods are to be inspected at regular intervals
and prices verified and tallied with purchase invoices.
(ii) By visiting factory/godown by officials and valuers like cost accountants
(iii) Follow up of account ensuring payment to creditors for stock and collection
of debtors thus avoiding diversion/misuse of funds.

Precautions to be taken
(i) Advances against goods should be restricted to genuine traders and not
to speculators.
(ii) Loans must be given for short periods, since the quality and thereby the
value of the security is likely to diminish.
(iii) The banker must have a working knowledge and gather information of
the different types of goods regarding their character, price movements,
storage value, etc.
(iv) The banker should confirm the state of goods.
(v) The goods should be insured against loss by theft or fire. Banking Laws and
Operations - I (69)
Banking Laws and (vi) The banker should verify and confirm the title of the borrower to the
Operations - I goods by inspecting the invoices or cash memos.
(vii) The banker as a Pawnee is liable, if reasonable care is not taken of the
goods pledged. He should therefore, take proper care for their storage
NOTES and also take reasonable steps to protect them from damage and pilferage.
(viii) The price of the goods must be accurately ascertained.
(ix) Necessary margin must be taken by the banker to protect him against
fluctuations in the price of goods.
(x) The banker must obtain absolute or constructive possession of the goods.
(xi) In the case of hypothecated goods, the bank should obtain from the
borrower a written undertaking that the goods are not charged to any
bank or creditor and will not be so charged as long as the borrower is
indebted to the bank. The banker should obtain at regular periods
certificates regarding the quantity and valuation of the goods, which should
be physically verified by the banker.

Documents of Title to Goods

What are Documents of Title to Goods?
As per the Section 2(4) of the Sale of Goods Act, 1930, a document of title
to goods is 'a document used in the ordinary course of business as a proof of
possession or control of goods authorizing or purporting to authorize either, by
endorsement or delivery, the possessor of the documents, to transfer or receive the
goods thereby represented.' Thus, the essential requisites of a document of title to
goods are:
(i) The mere possession of the documents creates a right either by virtue of
law or trade usage, to possess the goods represented by the documents.
(ii) Goods represented by the documents can be transferred by endorsement
and/or delivery of the documents.
(iii) The transferee of the documents can take delivery of the goods in his
own right.
(iv) Although they appear to be negotiable instruments, documents of title to
goods are not negotiable instruments. The title of bona fide transferee for
value can be affected by defects in the title of transferor.

They may be called quasi-negotiable instruments.

Examples of documents of title to goods are bills of lading, dock warrant,
warehouse-keeper's certificate, railway receipts, delivery orders, etc. Documents
of title to goods must be distinguished from other documents like the warehouse-
keeper's non-transferable receipts, which are mere acknowledgement of the goods.
Documents of title to goods are preferred by bankers because under Section 52(2)(e)
of the Presidency Towns Insolvency Act, 1909, and Section 28(3) of the Provincial
Insolvency Act, 1920, possession of goods represented by such instruments duly
endorsed in his favour are taken out of the order and disposition of the insolvent.
The significance of this is that in case the borrower becomes insolvent, the Official
Receiver or Official Assignee as the case may be, cannot include such goods in
the assets of the insolvent.

Merits of this Security

(i) By mere pledge of the instruments the goods are pledged and serve as a
Banking Laws and good security.
(70) Operations - I
 (ii) The person in possession of the document can transfer the goods by Types of Securities
endorsement and/or delivery. The transferee thereafter is entitled to take in Banks
delivery of the goods in his own right.
(iii) The documents are easily transferable, and the formalities involved are
less compared to mortgage or assignment. NOTES

Demerits of this Security

(i) Possibility for fraud and dishonesty
Since the bill of lading or a railway receipt or a warehouse-keeper's
certificate does not certify or guarantee the correctness of the contents of the
bags or packages, the banker will have no remedy against the carrier or warehouse
keeper, if they turn out to be containing worthless goods.
(ii) Forged and altered documents
The documents might be forged ones, or even if genuine, the quantity may
be altered.
(iii) Not Negotiable documents
The document being "Not Negotiable", the transferee of such documents
will not get a better title than that of the transferor. Therefore, if the person who
pledged the documents has a defective title, the banker will not acquire a better
title.
(iv) Unpaid vendor's right of stoppage in transit:
Under the Sale of Goods Act, 1930, an unpaid vendor has the 'right of
stoppage in transit' and he is entitled to direct the carrier that the goods need not be
delivered, if not already done. If this right is exercised by the unpaid vendor, the
banker cannot obtain the goods and his security is of no value.
(v)
In the case of lost documents, delivery of the goods is allowed on the
execution of an indemnity bond, this option may be misused by the borrower by
selling the goods to some other customer who may take delivery of the goods
declaring that he had lost/misplace the document and indemnifying the carrier. To
avoid such a contingency, the banker can give notice to the carrier regarding his
interest and the pledge.

Precautions to be taken by the banker

(i) The documents must be examined thoroughly to ensure that they are
genuine and of recent origin. In the case of bills of lading, they are prepared
generally in triplicate and as such all the copies must be obtained by the
banker. Otherwise, the carrier is released from his obligation by delivering
the goods on the presentation of any one copy containing ostensibly regular
endorsements.
(ii) The banker should ensure that the documents do not contain any onerous
clauses or prejudicial remarks about the condition of goods received.
(iii) Banker should ensure that the goods are adequately covered by insurance
for full value against risks of theft, fire, damage in transit, etc., and in the
case of goods shipped by sea, all the marine risks should be covered.
(iv) Banker should ensure to get consignee copy and banks name being entered
as consignee, so that endorsement/transfer of title is specific.
Banking Laws and
Operations - I (71)
Banking Laws and Trust Receipt
Operations - I
Whenever the bank releases documents of title to goods to the borrower
without payment being made, then a 'Letter of Trust' should be taken. So also in
the case of goods hypothecated to the bank. The reasons are as follows:
NOTES (i) The borrower on sale of the goods has to hold proceeds in trust for the
banker.
(ii) The goods taken under such trust receipts or the sale proceeds thereof,
are not available to the official receiver in case the borrower becomes
insolvent.

A Trust letter incorporates the following clauses

(i) Borrower's recognition, of bank's rights in the goods as security and in
case of sale, the proceeds, thereof.
(ii) Borrower's, undertaking to hold the goods or sale proceeds thereof, in
trust for the banker.
CHECK YOUR (iii) Borrower's undertaking, to ensure proper storage and insurance, at his
PROGRESS cost.
(iv) Borrower's undertaking to direct the buyer to pay the monies directly to
Describe Life Policies the banker, if so required by the banker.
as a Security for the (v) Borrower's undertaking to return unsold goods on banker's request or
Loan/Advance? dispose of the same as directed by the banker.

5.6 Life Policies as a Security for the Loan/Advance

Purpose of Life Policy
A life policy is taken for two purposes:
(i) It is a source of income for the dependents of the assured in case of his
death.
(ii) It is an ideal form of saving since along with income tax deduction on the
premium, paid loans can be raised on the policies in times of need.

Advantages
(i) Life insurance business being highly regulated and permitted only to
companies having sound financial health, the banker need not doubt the
realisation of the policies, which will be done without any difficulty, if the
policy and the claim are in order.
(ii) The assignment of the policy in favour of the banker requires very little
formalities and the banker obtains a perfect title.
(iii) The longer the period for which the policy has been in force, the greater
the surrender value. It is also useful as an additional security because, in
the event of the borrower's death, the debt is easily liquidated from the
proceeds of the policy.
(iv) The security can be realized immediately on the borrower's default of
payment by surrendering the policy to the insurance company.
(v) The policy is a tangible security and is in the custody of the bank. The
banker only has to ensure that regular payment of premiums is made.
Banking Laws and
(72) Operations - I
Disadvantages Types of Securities
(i) If the premium is not paid regularly, the policy lapses and reviving the in Banks
policy is complicated.
(ii) Insurance contracts being contracts of utmost good faith, any
misrepresentation or non-disclosure of any particulars by the assured NOTES
would make the policy void and enable the insurer to avoid the contract.
(iii) The person (proposer) who has obtained the policy must have an insurable
interest in the life of the assured or the contract is void.
(iv) The policy may contain special clauses, which may restrict the liability of
the insurer.
(v) When the banker accepts a policy coming under Married Women
PropertyAct he must ensure that all the parties sign in the bank's form of
assignment.
(vi) There is facility to obtain the duplicate policy if the original is lost. This
can be misused by persons by obtaining duplicate policies. Banker should CHECK YOUR
therefore, verify that no duplicate policy has been issued and there are no PROGRESS
encumbrances on the policy.
Describe Book Debts
Precautions as a Security for the
Loan/Advance?
(i) The policy must be assigned in favour of the bank and should be sent
directly to the insurance company for registration and ensured that only
authorized office of Insurance Company has noted assignment.
(ii) The bank should see that the age of the assured is admitted. (iii) The
banker should ensure the regular payment of premium.

5.7 Book Debts as a Security for the Loan/Advance

Borrowers can take advances by assigning book debts in favour of the
bank. Section 130 of the Transfer of Property Act, permits assignment of actionable
claim and the procedure to be followed is:
(i) The assignment must be in writing and signed by the transferor or his
duly authorised agent
(ii) Notice of the assignment in writing must be given to the debtor; and
(iii) The assignment may be absolute or by way of charge

Legal Implication of assignment

(i) The assignee can sue in his/ their own name and can give a valid discharge
(ii) The debtor can exercise any right of set off against the assignee, which
but for such transfer, he could have exercised against assignor
(iii) As an actionable claim includes future debts, there can be a valid
assignment of future debts as well

Precautions to be taken
(i) The value of the security depends on the solvency of the debtor and his
right of set off, if any. The banker must enquire into both aspects
(ii) The instrument of assignment must be in writing and duly signed in the
presence of the banker, signed by the assignor or his duly authorized
agent Banking Laws and
Operations - I (73)
Banking Laws and (iii) The banker must serve notices of assignment on debtors, who must be
Operations - I asked to acknowledge its receipt and confirm:
(a) The amount of the debt
(b) His right of set off, if any, and
NOTES
(c) Whether he has received notice of prior assignments, if any
(iv) An undertaking from the borrower should be taken that the amount of
debts collected directly if any by him will be passed on to the banker,
towards the loan account and operations in account be controlled to ensure
this compliance
(v) Where the book debts are as assigned by a joint stock company, the
charge must be registered with the Registrar of Joint Stock Companies.

5.8 Fixed Deposit as a Security for the Loan/Advance

CHECK YOUR
PROGRESS When money deposited by a customer is not repayable on demand and is
payable on the expiry of a specified period from the date of deposit such a deposit
Describe Fixed is called a 'Fixed Deposit'. The banker evidences a deposit by issuing a receipt
Deposit as a Security known as fixed deposit receipt. Interest, is paid at regular intervals at a specified
for the Loan/ rate on such deposits. Banks usually permit depositors to borrow against the deposit.
Advance? This security is certainly the most valuable, as the money represented by the receipt
is already with the bank and there is no problem of valuation or enquiring the title,
or the problem of storage and costs associated with storage.
Precautions
(i) The banker should grant the advance only to the person in whose name
the money is deposited. Banker should not advance against fixed deposit
receipts of other banks. This is because the banker who has received the
deposit will have a general lien over such monies. Even if the lending
bank gives notice to the bank, which has received the deposit, the latter
may even refuse to register the lien in favour of the lending bank.
(ii) If, the deposit is in joint names the request for loan must come from all of
them.
(iii) When the deposit receipt is taken as security, the banker should ensure
that all the depositors duly discharge it on the back of the instrument,
after affixing the appropriate revenue stamp. In addition to this, the banker
should obtain a letter of appropriation which authorizes the banker to
appropriate the amount of the deposit on maturity or earlier towards the
loan amount.
(iv) After granting the advance, the banker must note his lien in the fixed
deposit register to avoid payment by mistake and the lien, must also be
noted on the receipt itself.
(v) Advance should preferably not be made against fixed deposit receipt in
the name of a minor, unless a declaration is taken from guardian, that
loan will be utilized for benefit of the minor.
(vi) Where the money is being advanced against the fixed deposit receipt
issued by another branch, the FDR duly discharged must be sent to the
branch, where such money is deposited, for the following purposes:
(a) To verify the specimen signature of the depositor
(b) To ensure that no prior lien exists on the fixed deposit receipt
Banking Laws and
(74) Operations - I
 (c) To mark lien on the FDR and the FDR register, in favour of branch Types of Securities
advancing money. in Banks

(vii) Sometimes, a person may approach for advances by offering the fixed
deposit receipts held by third parties as security. In such a case, the fixed
deposit receipt must be duly discharged, by the third party, i.e., FD holder NOTES
and he should declare in writing the bank's right to hold the deposit receipt
as security, and also to adjust the deposit amount towards the loan account
on maturity or on default in repayment of installment if any.

5.9 Supply Bills as a Security for the Loan/Advance

Supply bills arise in relation to transactions with the Government and public
sector undertakings. A party might have taken a contract for execution, and he is
entitled to progressive payments based on work done, for which he has to submit
bills in accordance with the terms and conditions of the contract. Similarly, parties CHECK YOUR
who have accepted tenders for supply of goods over a period are entitled to payments PROGRESS
on the supply of goods, for which they submit bills in accordance with the terms of
the contract. These bills are known as supply bills. Describe Supply Bills
as a Security for the
Procedure followed in respect of supply bills Loan/Advance?
(i) The supplier delivers the goods supported by a delivery challan and
produces the documents. The appropriate authority of the government
department inspects these goods and accepts for payment on due date
and the supplier obtains an inspection note. In the case of contracts, an
engineer's certificate regarding work done is obtained.
(ii) The supplier or the contractor as the case may be, prepares the bill for
obtaining payment. Government departments take quite some time to
verify the bills and pass them for payment. Therefore, the supplier or
contractor submits these bills together with the accepted delivery challan
and inspection note or the engineer's certificates to the appropriate
Government department through the banker and requests the banker to
advance against such bills.
These bills do not enjoy the status of negotiable instruments. They are in
the nature of debts and are assigned, in favour of the banker for payment, after
affixing a revenue stamp for having received the amount. The bank should also
obtain a letter from the supplier or contractor, requesting the appropriate department
to make the payment directly to the banker.

Risks involved in advancing against supply bills

(i) Although the advance is self-liquidating in nature, in certain cases it can
take quite some time before the advance is realized because of
administrative and other Governmental procedures.
(ii) It is virtually a clean advance and the bank may not realize the full amount,
because of the possibility of counter claim or the right of set off by the
Government, as the charge is only by way of assignment.
(iii) Sometimes, the Government may not pass the bills for full payment because
of the unsatisfactory quality of goods or defective work done by the
contractor or delays in the completion of work.
Banking Laws and
Operations - I (75)
Banking Laws and Precautions to be taken by the banker
Operations - I
(i) Advances against supply bills should be made only to borrowers who
have sufficient experience in Government business and Government
regulations.
NOTES
(ii) The contract between the supplier and the Government department should
be scrutinized by the banker, to know the volume of transaction, period of
supply, rates agreed upon and various other terms and conditions. The
Government will not pass the bills unless there is faithful adherence to
the terms and conditions by the supplier.
(iii) The banker should obtain a power of attorney from the supplier authorizing
him to receive the money. The same should be registered with the
appropriate Government department.
(iv) The banker should obtain the inspection note or the engineer's certificates
along with the bills. There should be no adverse remarks in the inspection
report regarding the quality and quantity of goods supplied.
(v) There are two types of bills that are submitted by the suppliers. They are:
(a) Interim bills against which Government pays eighty to eighty five per
cent of the amount.
(b) Final Bills for the balance of twenty to fifteen per cent which will be
paid only after complete verification of goods at the point of destination.
Because of the delay involved in the settlement of final bills, banks should
prefer the interim bills for advancing and final bills only for collection.
Keep sufficient margin, to cover advance with interest thereon from
proceeds to be received.
(vi) Banker must reserve the right of demanding the repayment of advance,
if the bills remain unpaid for a specified period. The banker, in other
words, treats the bills as only items for collection and the advances are
recovered.
When land/building is offered as a security, it is charged to the bank by a
mortgage. Mortgages are of six kinds, though as a banker you would be dealing in
only three of them. The law, relating to mortgages is dealt with in the Transfer of
Property Act, 1882, and more particularly Sections 58 to 99 and 102 to 104. We
shall now study these provisions and see how they affect us, as bankers in our
business of lending.

5.10 Key concepts

Land has over other types of securities is that its value generally increases
with time.
A freeholder is the absolute owner of his land and is able to deal with it as
he likes.
Debenture is a document issued by a company acknowledging its
indebtedness to the bearer or a registered holder.

Banking Laws and

(76) Operations - I
 Types of Securities
5.11 Summary in Banks

l One of the reasons why banks should hold valid collateral security is, banks
lend against such security (movable/immovable assets, financial instruments,
NOTES
personal and corporate securities)
l Banks as lenders should be careful in accepting collateral security (primary/
secondary) from borrowers.
l Different kinds of securities are obtained based on (i) type of finance (ii)
nature of security (iii) type of borrowers, etc.,
l Collateral security if properly obtained with all collateral documents as
appropriate would assist the banks to protect the interests of the banks in
case the borrower defaults. These securities supported by correct and valid
documents would assist the banks in recovery process as well.
l Banks loans and advances are secured to protect the banks against risks.

5.12 Exercise
Fill in the blanks
1. Over the other type of securities, the value of ______ generally increases
with time.
(Land, Shares, Supply bills)
2. Ascertaining the title of the owner, creating a charge is costly are some of
the disadvantages of having ______as a security.
(Land, Shares, Supply bills)
3. In case of ________ as a security Value of the security can be ascertained
without any difficulty.
(Land, Shares, Supply bills)
4. __________ is a document issued by a company acknowledging its
indebtedness to the bearer or a registered holder.
(Debenture, shares, life policy)
5. Advances against _______ are normally given for short periods and therefore
the risk of the banker is considerably reduced.
(goods, supply bills, shares)
6. The mere possession of the documents creates a __________ either by
virtue of law or trade usage, to possess the goods represented by the
documents.
(obligation, necessity, right)
7. ____________ arise in relation to transactions with the Government and
public sector undertakings.
(goods, supply bills, shares)
8. Whenever the bank releases documents of title to goods to the borrower
without payment being made, then a ___________ should be taken.
(letter of trust, letter of credit, letter of authority) Banking Laws and
Operations - I (77)
Banking Laws and 9. __________ as a security is an ideal form of saving since along with income
Operations - I tax deduction on the premium, paid loans can be raised on the policies in
times of need.
(Debenture, shares, life policy)
NOTES
10. When money deposited by a customer is not repayable on demand and is
payable on the expiry of a specified period from the date of deposit such a
deposit is called a ________'.
(savings, fixed deposit, only deposit)

[ANS: 1)land 2)land 3)shares 4)debenture 5)goods 6)right 7)supply bills

8)letter of trust 9)life policy 10)fixed deposit ]

5.13 Further Readings & References

1. M.L.Tannan, revised by : Banking Law and Practice, Wadhwa & Company,
Nagpur C.R. Datta & S.K. Kataria
2. A.B. Srivastava and : Seth's Banking Law, Law Publisher's India (P) Limited
K. Elumalai
3. R.K. Gupta : BANKING Law and Practice in 3 Vols. Modern Law Publications.
4. Prof. Clifford Gomez : Banking and Finance - Theory, Law and Practice, PHI
Learning Private Limited
5. J.M. Holden : The Law and Practice of Banking, Universal Law Publishing.

Banking Laws and

(78) Operations - I
 Charge over Securities
UNIT 6
CHARGE OVER SECURITIES
Structure NOTES

6.0 Introduction
6.1 Objectives
6.2 Charging the Security
6.3 Pledge of Security
6.3.1 Requirements for a Valid Pledge
6.3.2 Important features of Pledge
6.3.3 The Rights of Pledgee are as follows:
6.3.4 Precautions required for Pledge:
6.4 Hypothecation over Securities
6.4.1 Hypothecation- Meaning
6.4.2 Important features of hypothecation
6.4.3 Other important aspects of Hypothecation
6.4.4 Precautions required for Hypothecation
6.5 Difference between Hypothecation and Pledge
6.6 Lien
6.6.1 Lien - Important aspects
6.7 Assignment
6.7.1 Assignment - important features
6.8 Mortgage
6.9 Priority of Mortgages
6.10 Limitation Period in Mortgages
6.11 Registration of Charge
6.12 Key Concepts
6.13 Summary
6.14 Exercise
6.15 Further Readings & References

6.0 Introduction
A charge is a right created by any person including a company referred to
as "the borrower" on its assets and properties, present and future, in favour of a
financial institution or a bank, referred to as "the lender", which has agreed to
extend financial assistance.
Section 2(16) of the Companies Act, 2014 defines charges so as to mean
an interest or lien created on the property or assets of a company or any of its
undertakings or both as security and includes a mortgage. The following are the
essential features of the charge which are as under:
1. There should be two parties to the transaction, the creator of the charge
and the charge holder.
2. The subject-matter of charge, which may be current or future assets
and other properties of the borrower. Banking Laws and
Operations - I (79)
Banking Laws and 3. The intention of the borrower to offer one or more of its specific assets
Operations - I or properties as security for repayment of the borrowed money together with
payment of interest at the agreed rate should be manifested by an agreement
entered into by him in favour of the lender, written or otherwise.
NOTES A charge may be fixed or floating depending upon its nature.

6.1 Objectives
After reading this unit, you should be able to:
- Understand the concept of Pledge, Hypothecation, Mortgage, Assignment,
and Lien
- Understand the concept of charge
- Different types of charges created on the securities of the bank.

CHECK YOUR 6.2 Charging the Security

PROGRESS
Charging a security means that the borrower gives the lending bank a right to:
(i) transfer the title from the borrower to the bank
What is charging the (ii) take possession of the securities
security? (iii) recover the dues through legal course

Creation of charge on securities is done as per the nature of the security as under:
1. Hypothecation (for movable stocks such as, goods, plant and machinery)
2. Pledge (for movable stocks)
3. Mortgage (in respect of immovable property)
4. Assignment of debts (life like insurance policy/book debts)
5. Lien on deposits with the bank
CHARGES
PLEDGE HYPOTHECATION MORTGAGE ASSIGNMENT LIEN

6.3 Pledge of Security

Pledge means bailment of goods for the purpose of providing security for
payment of debt or performance of promise. Section 172 of Indian Contract Act,
1872 defines pledge.

6.3.1 Requirements for a Valid Pledge

There should be delivery of goods (bailment). The bailment (delivery of
goods) must be by or on behalf of the debtor. The bailment (delivery of goods)
must be for the purpose of providing security for the payment of a debt or
performance of a promise.
For example, an agriculturist is sanctioned a gold loan by his banker. The
borrower delivers his gold ornaments to the bank as a security for the gold loan.
The borrower pledges gold ornaments to raise the loan. In this case, the agriculturist
has created a valid pledge.
(1) there is bailment of gold (delivery of gold)
(2) The bailment of gold is made by the debtor (borrower)
Banking Laws and (3) The bailment of gold is provided as a security to the gold loan (debt)
(80) Operations - I
6.3.2 Important features of Pledge Charge over Securities

(i) The person, whose goods are bailed is called pawnor or pledger, and to
whom the goods are pledged as pawnee or pledgee.
(ii) Ownership of the property is retained by the pledger, which is subject
NOTES
only to the qualified interest which passes to the pledgee by the bailment.
(iii) The essential feature of a pledge is the actual or constructive delivery
of the goods to the pledgee. By constructive delivery it is meant that
there will be no physical transfer of goods from the custody of the
pledger/ pawnor to the pledge/ pawnee. All that is required is that the
goods must be placed in the possession of the pawnee or of any person
authorized to hold them on his behalf.
(iv) The delivery of the goods may be 'physical' when goods are actually
transferred and 'symbolic' as in the case of delivery of the key or
'constructive' as in the case of attornment.
(v) Pledge can be created only in the case of existing goods (and not on
future goods) which are in the possession of the pledger himself.
(vi) Since the possession of goods is the important feature of pledge and
therefore, pledge is lost when possession of the goods is lost.
(vii) An agreement of pledge also known as deed of pledge may be implied
from the nature of the transaction or the circumstances of the case
(viii) To protect the interests of the concerned parties the agreement in writing
should clearly indicate the terms and conditions.
A valid pledge can be created by (i) the owner of the goods (ii) a mercantile
agent, subject to the following terms and conditions are satisfied (iii) the seller of
goods, who continues to hold the goods even after sale, can create a valid pledge.
The pledgee must act in good faith and without notice of the previous sale.

6.3.3 The Rights of Pledgee are as follows:

1. Right of Retainer: As per Section 173 of the Indian Contract Act, the
pawnee or pledge is entitled to the good pledged not only for non-payment
of debt or non- performance of promise, but also for the interest on the
debt and for all expense incurred for preservation of the goods pledged.
2. Right against Third Parties: A pledge has the same remedies against
third persons, as the owner himself would have, if he is deprived of his
goods.
3. No Right to Retain in case of Other Debts: In the absence of a contract
to the contrary, the pledge cannot retain goods for a debt or a promise,
other than the promise or debt for which the said goods are pledged.
4. Other rights: In case the Pledger makes default, then the Pledgee has
three important rights:
(i) He may sue the pawnor upon the debt or promise
(ii) He may retain the pledged goods as collateral security; or
(iii) He may sell it after giving the pledger reasonable notice of the sale

6.3.4 Precautions required for Pledge:

(i) Banks, as pledgee should ensure that the pledger has good title to the
goods/assets
(ii) Bank verifies and satisfies that the contract of pledge (deed of pledge) Banking Laws and
Operations - I (81)
Banking Laws and is complete in all respects, and it covers all important clauses to protect
Operations - I the interest of the bank.
(iii) Bank carryout regular inspection of goods pledged to ensure the quality,
quantity, value, and insurance of such goods are as required and as per
NOTES the stock statements.
(iv) Bank takes reasonable care of the goods (like a man of ordinary prudence
would under similar circumstances take) to protect the value of the
goods and prevent any loss

6.4 Hypothecation over Securities

6.4.1 Hypothecation- Meaning
The term "Hypothecation' means a charge created on any movable asset/
property, for a loan borrowed by the owner of goods/movable assets (existing or
CHECK YOUR future) without transferring, either the property or the possession to the lender.
PROGRESS
The Securitization and Reconstruction of Financial Assets and Enforcement
of Security Interest Act,2002 (SARFAESI Act) defines hypothecation thus :
What is
Hypothecation over "Hypothecation means a charge in or upon any movable property, existing
or future, created by a borrower in favour of a secured creditor without delivery of
Securities?
possession of the movable property to such creditor, as a security for financial
assistance and includes floating charge and crystallisation of such charge into fixed
charge on movable property"

6.4.2 Important features of hypothecation:

1. The charge hypothecation is applicable to movable assets.
2. The ownership and possession are held by the borrower of the assets
(security).
3. The document (hypothecation agreement) provides for a covenant,
whereby the borrower agrees to give possession of the goods (movable
assets) when called upon to do so by the creditor. Upon taking over the
possession of goods, the charge is treated as pledge.

6.4.3 Other important aspects of Hypothecation:

Banks should exercise precautions while handling lending against
hypothecation for the following reasons:
(a) The possession of the goods/assets are held by the borrower, hence, it is
always difficult for the creditor (lender) to have control over such goods.
(b) The borrower may sell the hypothecated stocks, and pay other creditors.
(c) The possibility of raising double finance against the same stock cannot
be ruled out. For example the borrower may hypothecate the same
stocks to another bank, the goods may be latter pledged to another
creditor.
(d) In case of default, the realization of assets may be difficult and costly.

6.4.4 Precautions required for Hypothecation:

In view of the above difficulties, banks are required to take certain
precautions in respect of goods and assets hypothecated, to protect the interest of
Banking Laws and the banks.
(82) Operations - I
 1. Banks should ensure that the borrower enjoys hypothecation facility Charge over Securities
with only one bank and not with multiple banks. An undertaking to this
effect in writing should be taken by the bank to avoid any risk.
2. Banks should display boards in the show room, shops where
hypothecated goods are displayed/stored, indicating that such goods are NOTES
hypothecated to bank.
3. Banks should ensure that
(i) periodical stock statements are submitted by the borrower.
(ii) stock statements should contain relevant, and correct details as regards
to quantity, quality and price.
(iii) Regular inspections are carried out to verify the facts mentioned in
the stock statements
(v) In case of any discrepancy, depreciation in the value of stock,
appropriate action should be taken by the bank immediately by calling
for additional securities and increase in the margin.
CHECK YOUR
4. If the borrower is a limited company, the hypothecation charge must be
PROGRESS
registered with the Registrar of
Companies (ROC) within a period of 30 days of its creation. This is Difference between
very important, otherwise, the charge will be void against the liquidator Hypothecation and
and/or any creditor of the company.
Pledge?

6.5 Difference between Hypothecation and Pledge

HYPOTHECATION PLEDGE
A Applicable to movable goods/assets Applicable to movable goods/assets
B Ownership remains with the borrower Ownership remains with the borrower
C Possession remains with the borrower Possession is held by the lender
D Defined under SARFAESI Act Defined under Indian Contract Act
E Legal document is hypothecation Agreement Legal document is deed of pledge
F In case the borrower is a Limited Company In case the borrower is a Limited
registration of charge with ROC is a must Company, registration of charge with
ROC is not applicable

6.6 Lien
Section 171 of the Indian Contract Act,1872 gives to the banker an absolute
right of general lien on all goods and securities received by the banker. The banker
has general lien on all deposits. If the deposit receipt is given as a security for
raising a loan or discharging an obligation then the lien on such deposit receipt, is a
particular lien, and it would exist till the debt is cleared or the obligation is fulfilled.

6.6.1 Lien - Important aspects:

General lien covers the entire amount due to the bank from the borrower/ debtor.
Banker's General Lien:
This is applicable in the following situations:
- when a banker receives goods and securities for a purpose
- lien is applicable for the goods and/or securities which are belonging to
Banking Laws and
a person who has delivered them to the banker Operations - I (83)
Banking Laws and - there is no contract to the contrary and the debt is not barred by limitation
Operations - I
A banker's lien is also called as an implied pledge. A banker has the right to
retain and if necessary can also sell the goods and/or securities charged in his
favour. As pledgee, a banker can sell the goods/securities pledged to him.
NOTES
A banker cannot exercise his right of lien in following situations:
1. In case when goods and securities are not obtained by him in the ordinary
course of business:
2. In case of Safe Custody, when a banker accepts goods/securities of a
customer to be kept in safe custody. In this case the relationship of
banker and customer is that of the bailee and bailer. Here the banker
acts as a trustee and not as a lender/creditor.
3. When the goods or security are left inadvertently or through oversight in
the bank premises, the banker cannot exercise his right of lien on them.
4. When money is deposited by a customer with a request to transfer to
another branch, the banker cannot exercise the right of lien. This is
CHECK YOUR applicable even the applicant for the transfer of funds is a borrower as
PROGRESS well.
5. The banker cannot have the right of lien and right of set off at the same
What is assignment? time.

6.7 Assignment
Assignment is a type of charge on certain securities offered to a creditor.
It is transfer of right, for a property or debt.
Two persons are involved, the person who transfer his right is called the
assignor and the beneficiary is called assignee. For example when a bank gives
loan to a borrower against his book debts (future receivables), two parties involved
are (i) the borrower (debtor) and the banker (creditor). The borrower/debtor, who
is called the assignor, transfers his rights of receiving the funds from his customers..
The banker (lender/creditor) to whom the rights are transferred is called as the
assignee.

6.7.1 Assignment - important features:

1. Section 130 of the Transfer of Property Act, states that the transfer of
an actionable claim can be effected only by the execution of an instrument
in writing signed by the transferor or by his duly authorized agent.
2. An actionable claim is defined as a claim to any debt other than a debt
secured by {(i) mortgage of immovable property or (ii) hypothecation or
(iii) pledge of movable property or (iv) any beneficial interest in any
movable property} not in the possession of the claimant.
3. A borrower may assign any of the following items to secure a loan viz.,
(i) book debts (ii) life insurance policies (iii) money due from Government
department.
4. An assignment can be absolute or by way of security
5. An assignment may be a legal or equitable assignment
6. As regards of book debts, the assignor informs his debtor, in writing,
about the details of the assignee's full communication details like name
Banking Laws and address e mail and telephone numbers etc., to enable him to pay the
(84) Operations - I
 amount to the assignee directly until further instructions from his client. Charge over Securities
(i) In the case of a life insurance policy, is assigned by an endorsement
on the back of the policy or by a special deed of assignment. Notice of
such assignment must be given to the insurer by the assignor or assignee,
to enable the life insurance company to register the assignment in the NOTES
records of the company records and act as per instructions.

6.8 Mortgage
Section 58(a) of the Transfer of Property Act, 1882 defines a mortgage as
follows:
'A mortgage is the transfer of interest in specific immoveable 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 is called the 'mortgagor' and the transferee a 'mortgagee'
CHECK YOUR
the principal money and interest of which payment is secured is called mortgage
PROGRESS
money and the instrument by which the transfer is effected is called the 'mortgage
deed'.
What is mortgage?
(a) Ingredients of Mortgage
From the above definition of mortgage, the following are the requirements
of a mortgage:
(i) There should be transfer of interest in the property by the mortgagor
(the owner or lessor).
(ii) The transfer should be to secure the money paid or to be paid by way of
loan.

(b) Mortgage of Land - Various Types

The Transfer of Property Act contemplates six different kinds of mortgages.
They are:
(i) Simple mortgage
(ii) Mortgage by conditional sale
(iii) Usufructuary mortgage
(iv) English mortgage
(v) Mortgage by deposit of title deeds (Equitable mortgage)
(vi) Anomalous mortgage

(i)Simple mortgage
According to Section 58(b) of the Transfer of Property Act, a simple
mortgage is a transaction whereby, 'without delivering possession of the mortgaged
property, the mortgagor binds himself personally to pay the mortgage money and
agrees, expressly or impliedly, that in the event of his failing to pay according to his
contract, the mortgagee shall have a right to cause the mortgaged property to be
sold by a decree of the Court in a suit and the proceeds of the sale to be applied so
far as may be necessary in payment of the mortgage money.

Features of simple mortgage

(i) The mortgagee has no power to sell the property without the intervention Banking Laws and
of the court Operations - I (85)
Banking Laws and In case there is shortfall in the amount recovered even after sale of the
Operations - I mortgaged property the mortgagor continues to be personally liable for
the shortfall.
(ii) The mortgagee has no right to get any payments out of the rents and
NOTES produce of the mortgaged property
(iii) The mortgagee is not put in possession of the property
(iv) Registration is mandatory if the principal amount secured is ' 100 and
above

(ii) Mortgage by way of conditional sale

As per Section 58(c) of the Transfer of Property Act, a mortgage by way
of a conditional sale of the property, is a transaction whereby, the mortgagor ostensibly
sells the mortgaged property on the condition that:
(a) on default of payment of the mortgage money on a certain date, the sale
shall become absolute, or
(b) on such payment being made the sale shall become void; or
(c) on such payment being made, the buyer shall transfer the property to
the seller.
No such transaction shall be deemed to be a mortgage of conditional sale,
unless the condition is embodied in the document, which effects or purports to
effect the sale.

Essential features of Mortgage by way of conditional sale

(i) The sale is ostensible and not real.
(ii) If the money is not repaid on the agreed date, the ostensible sale will
become absolute upon the mortgagor applying to the Court and getting a
decree in his favour. The mortgagor in such a case loses his right to
redeem his property.
(iii) The mortgagee can sue for foreclosure, but not for sale of the property.
Foreclosure, means the loss of the right possessed by the mortgagor to
redeem the mortgaged property.
(iv) There is no personal covenant for repayment of the debt and therefore
bankers do not prefer this type of mortgage. The mortgagee cannot
look to the other properties of the mortgagor in case the mortgaged
property proves insufficient.

(iii) Usufructuary mortgage

According to Section 58(d) of the Transfer of Property Act, 'a Usufructuary
mortgage is a transaction in which (a) the mortgagor delivers possession expressly,
or by implication and binds himself to deliver possession of the mortgaged property
to the mortgagee, and (b) authorizes the mortgagee, to retain such possession until
payment of the mortgage money and to receive the rents and profits accruing from
the property or any part of such rents and profits and to appropriate the same in
lieu of interest, or in payment of the mortgage money, or partly in lieu of interest
and partly in payment of the mortgage money.

Essential features of Usufructuary mortgage

(i) The mortgagee is put in possession of the mortgaged property. Here, by
Banking Laws and possession it is meant, the legal possession and not the physical possession.
(86) Operations - I For example, the mortgagor may continue to enjoy the physical possession
 as the lessee of the mortgagee or the mortgagor may be the caretaker Charge over Securities
of the property directing the tenants to pay rent to the mortgagee.
However, the deed must contain a clause providing for the delivery of
the property to the mortgagee and authorizing him to retain such
possession. NOTES
(ii) The mortgagee has the right to receive the rents and profits accruing
from the property. Such rents and profits or part thereof, may be
appropriated in lieu, of interest or in payment of the mortgage money or
partly for both.
(iii) Unless there is a personal covenant for the repayment of the mortgage
money, there is no personal liability for the mortgagor. Therefore, the
mortgagee cannot sue the mortgagor for repayment of the mortgage
debt; nor can he sue mortgagor for the sale or foreclosure of the
mortgaged property.
(iv) There is no time limit specified and the mortgagee remains in possession
of the property until the debt is repaid. The only remedy for the mortgagee
is to remain in possession of the mortgaged property and pay themselves
out of the rents and or profits of the mortgaged property. If the mortgagor
fails to sue for redemption within thirty years, the mortgagee becomes
the absolute owner of the property.

Bankers do not prefer this form of mortgage for the following reasons:
(i) There is no personal covenant to repay the debt.
(ii) As the mortgaged money can be recovered only by the appropriation of
rents and/or profits, it will take a very long time to recover money through
this process.

(iv) English Mortgage

According to Section 58(e) of the Transfer of Property Act, an 'English
Mortgage' is a transaction in which, the mortgagor binds himself 'to repay the
mortgage money on a certain date and transfers the mortgaged property absolutely
to the mortgagee, but subject to the provision that he will retransfer it to the
mortgagor upon payment of the mortgage money as agreed'.

Essential features of English Mortgage

(i) It provides for a personal covenant to pay on a specified date
notwithstanding the absolute transfer of the property to the mortgagee.
(ii) There is an absolute transfer of the property in favour of the mortgagee.
However, such absolute transfer is subject to a provision that the property
shall be re-conveyed to the mortgagor in the event of the repayment of
mortgage money.
(iii) The mortgagee can sue the mortgagor for the recovery of the money
and can obtain a decree for sale.
(v) Equitable mortgage or mortgage by deposit of title deeds
According to Section 58(f) of the Transfer of Property Act, 'Where a
person in any of the following towns, namely, the towns of Kolkata, Chennai and
Mumbai and in any other town which the State Government concerned may, by
notification in the official Gazette, specify in this behalf, delivers to a creditor or his
agent documents of title to immoveable property, with intent to create a security
thereon, the transaction is called a mortgage by deposit of title deeds,'. Banking Laws and
Operations - I (87)
Banking Laws and Documents of title
Operations - I
Documents of title or title deed in case of mortgage by deposit of title
deeds, shall be documents or instruments which relate to ownership of the mortgagor
over the property. In other words, by virtue of a document or instrument, if a
NOTES person has a right to peaceful possession and enjoyment of the immoveable property,
then such a document or instrument is called the title deed. In the case of Syndicate
Bank vs Modern Tile and City Works (1980 KL T 550); it was explained by the
learned Judges that documents of title or deed means the legal instrument which
proves the right of a person in a particular property.

Essential features of equitable mortgage

(i) Such a mortgage can be affected only in the towns notified by the State
Government. However, the territorial restriction refers to the place where
the title deeds are delivered and not to the situation of the property
mortgaged.
(ii) To create this mortgage, there must be three ingredients i.e., a debt, a
deposit of title deeds and an intention that the deeds shall be act as
security for the debt.

(vi) Anomalous mortgage

According to Section 58(g) of the Transfer of Property Act, 'a mortgage
which is not a simple mortgage, a mortgage by conditional sale and usufructuary
mortgage and English mortgage or a mortgage by deposit of title deeds within the
meaning of this Section, is called an "Anomalous Mortgage."

Essential features Anomalous mortgage

(i) It must be a mortgage as defined by Section 58 of the Transfer of
Property Act. (ii) It is negatively defined and should not be anyone of
the mortgages listed above.
(iii) Anomalous mortgages are usually a combination of two mortgages.
Examples of such mortgages are:
(a) a simple and usufructuary mortgage, and
(b) an usufructuary mortgage accompanied by conditional sale. There
may be other forms, molded by custom and local usage.
(c) Merits and Demerits of an Equitable Mortgage

Merits
(i) The borrower saves the stamp duty on the mortgage deed and the
registration charges. It involves minimum formalities.
(ii) It involves less time and can be conveniently created.
It can be done without much publicity and therefore, the customer's
position is not exposed to public gaze.

Demerits
(i) In case of default, the remedy is to obtain a decree for sale of the
property. Since, this involves going to the Court, it is expensive and time
consuming. This shortcoming can be overcome by inserting a covenant
Banking Laws and by which the mortgagee is given the power of sale. In that case, the
(88) Operations - I
 mortgage deed must be properly stamped and registered and the mortgage Charge over Securities
loses the advantage of being simple in procedure and less expensive.
(ii) Where the borrower is holding the title deeds in his capacity as a trustee
and equitable mortgage of the same is effected, the claim of the
beneficiary, under trust will prevail over any equitable mortgage. NOTES
Therefore, the banker has to make a proper scrutiny of the title deeds
before accepting them as a security.
(iii) The borrower may create a subsequent legal mortgage in favour of
another party. However, this possibility is not there, if the equitable
mortgagee holds the original title deeds. In India, there is no difference
between the two types of mortgages. According to Section 48 of the
Registration Act, 1908, a mortgage by deposit of title deeds prevails
against any subsequent mortgage relating to the same property. Similarly,
the title of the equitable mortgagee, is not defeated by any subsequent
sale without notice. However, to avoid any risk of this type, the equitable
mortgage should be accepted only after obtaining the original title deeds.
The law in England is slightly different. As between equitable mortgage CHECK YOUR
and legal (simple) mortgage, the latter prevails even though it is effected subsequently. PROGRESS
The law, regarding this is, as between law and equity, law prevails.
As between the equities, the prior in time prevails. What is Priority of
Pledge requires only a limited interest in the property and ownership remains Mortgages?
with the right of pledger. The Pawnee has 'special property' in the goods pledged
and can sell the same in the event of default by the pledger of course, after giving
reasonable notice. Pawnee has no right of foreclosure. He can only sell the property
to realize his dues.
Here the legal ownership passes to mortgagee, of course, subject to the
mortgagor to redeem the property. The mortgagee as a rule takes decree of a
Court of Law before having recourse against the property mortgaged. In certain
cases, the mortgagee can foreclose the property.

6.9 Priority of Mortgages

Indian Law of priorities is provided in Section 48 of the Transfer of
PropertyAct. The rule is based on maxim 'he has a better title who was first in
point of time.' It lays the general rule regarding priority of rights created by transfer
by a person at different times in or over the same immoveable property and provides
that, as between such rights, each later created right is subject to the rights previously
created. We may further see, as how the rule of priorities operates in respect of
different instruments creating mortgages.
(a) Priority among registered instruments
Section 47 of the Registration Act, 1908 provides that a registered document
operates, not from the date of its registration, but from the time of its execution.
Thus, a document executed earlier, though registered later than another, has priority
over the documents executed later.
(b) Priority between registered and unregistered instruments
Let us now deal with the exceptions to the rule, that priority is determined
by order of time, which either have been created by statute or owe their origin to
the ancient rule of Hindu Law, which required delivery of possession in the case of
a security of land. There are also some exceptions recognized in the Indian system
founded upon those general principles of justice and equity, which in the absence
of any express enactment, Indian judges are bound to administer, and which, have Banking Laws and
been mostly borrowed, from the English Law. Operations - I (89)
Banking Laws and The first exception is that contained in Section 50 of the Registration Act,
Operations - I which under certain circumstances allows a registered mortgage priority over
unregistered mortgage. However, it may be noted that prior mortgage by deposit
of title deeds is not affected by subsequent registered mortgage as the same need
NOTES not be registered. This is provided in Section 48 of Indian Registration Act.

6.10 Limitation Period in Mortgages

Article 62 of the Indian Limitation Act, 1963 provides limitation period for
filing of suit for recovery of mortgaged debt and sale of mortgaged property in the
event of non-payment of the mortgaged debt. Article 63(a) of the said Act provides
a limitation period, in case of foreclosure of the mortgaged property. The limitation
period for filing a suit for sale of mortgaged property is TWELVE YEARS, from
the date the mortgage debt becomes due. The limitation period for filing suit, for
foreclosure is THIRTY YEARS, from the date the money secured by mortgage
becomes due.
CHECK YOUR
PROGRESS
Enforcement of Mortgage - Some Important Aspects
What is Registration We will now learn some important aspects as to enforcement of mortgage.
of Charge? It may be noted that a banker, secures monies advanced by creating one of various
types mortgages mentioned above. Popular types of mortgages obtained by a banker
are:
(i) Mortgage by deposit of title deeds
(ii) Simple mortgage and in some cases
(iii) English mortgage.
Enforcement of all these types of mortgages is by way of filing a suit for
sale of mortgaged properties. The procedure for filing a suit for a sale is provided
for in the Code of Civil Procedure, 1908. The Section 16(c) of the Civil Procedure
provides that a suit for sale of mortgaged property shall be filed in the Court within
whose jurisdiction the mortgaged property is situated. Order 34 of the Code provides
for various things to be adhered to while filing suit for sale of mortgaged property.
When a suit for sale is filed, the Court after hearing the parties passes a preliminary
decree.
Through the preliminary decree it directs the mortgagor to pay the mortgage
debt within a certain period and in the event of his failure to pay the money due
under the mortgage, the Court orders for sale of mortgaged properties by passing
a final decree. After passing of the final decree, the mortgagee with the help of the
Court gets the mortgaged property sold in execution of the mortgage decree.

6.11 Registration of Charge

Section 77:
(1) It shall be the duty of every company creating a charge within or outside
India, on its property or assets or any of its undertakings, whether tangible
or otherwise, and situated in or outside India, to register the particulars
of the charge signed by the company and the charge-holder together
with the instruments, if any, creating such charge in such form, on payment
of such fees and in such manner as may be prescribed, with the Registrar
within thirty days of its creation: Provided that the Registrar may, on an
Banking Laws and
application by the company, allow such registration to be made within a
(90) Operations - I
 period of three hundred days of such creation on payment of such Charge over Securities
additional fees as may be prescribed: Provided further that if registration
is not made within a period of three hundred days of such creation, the
company shall seek extension of time in accordance with section 87:
Provided also that any subsequent registration of a charge shall not NOTES
prejudice any right acquired in respect of any property before the charge
is actually registered.
(Application for registration of creation, modification (other than those
related to debentures) including particulars of modification of charge by
Asset Reconstruction Company in terms of Securitization and
Reconstruction of Financial Assets and Enforcement of Securities
Interest Act, 2002 (SARFAESI))
(2) Where a charge is registered with the Registrar under sub-section (1),
he shall issue a certificate of registration of such charge in such form
and in such manner as may be prescribed to the company and, as the
case may be, to the person in whose favor the charge is created.
(3) Notwithstanding anything contained in any other law for the time being
in force, no charge created by a company shall be taken into account by
the liquidator or any other creditor unless it is duly registered under sub
section (1) and a certificate of registration of such charge is given by
the Registrar under sub-section (2).
(4) Nothing in sub-section (3) shall prejudice any contract or obligation for
the repayment of the money secured by a charge.

Section 78:
Where a company fails to register the charge within the period specified in
section 77, without prejudice to its liability in respect of any offence under this
Chapter, the person in whose favor the charge is created may apply to the Registrar
for registration of the charge along with the instrument created for the charge,
within such time and in such form and manner as may be prescribed and the
Registrar may, on such application, within a period of fourteen days after giving
notice to the company, unless the company itself registers the charge or shows
sufficient cause why such charge should not be registered, allow such registration
on payment of such fees, as may be prescribed:
Provided that where registration is effected on application of the person in
whose favor the charge is created, that person shall be entitled to recover from the
company the amount of any fees or additional fees paid by him to the Registrar for
the purpose of registration of charge.

Section 79:
The provisions of section 77 relating to registration of charges shall, so far
as may be, apply to:
(a) a company acquiring any property subject to a charge within the meaning
of that section; or
(b) any modification in the terms or conditions or the extent or operation of
any charge registered under that section.

Section 384:
(1) The provisions of section 71 shall apply mutatis mutandis to a foreign
company.
Banking Laws and
Operations - I (91)
Banking Laws and (2) The provisions of section 92 shall, subject to such exceptions, modifications
Operations - I and adaptations as may be made therein by rules made under this Act,
apply to a foreign company as they apply to a company incorporated in
India.
NOTES
Rule 3 (1):
(1) For registration of charge as provided in sub-section (1) of section 77,
section 78 and section 79, the particulars of the charge together with a copy of the
instrument, if any, creating or modifying the charge in Form No.CHG-1 (for other
than Debentures) or Form No.CHG-9 (for debentures including rectification), as
the case may be, duly signed by the company and the charge holder and filed with
the Registrar within a period of thirty days of the date of creation or modification
of charge along with the fee.

Purpose of the eForm

All the companies are required to file particulars for registration of charges
created or modified within specified period to concerned Registrar of Companies.
The charge can be created on various types of assets situated in or outside India
and may be created in favor of lenders such as Banks or financial institutions.
Every charge that is created or modified by the company is required to be filed in
eForm CHG-1 to concerned RoC in case of Indian Company and RoC, Delhi in
case of a foreign company.

Particulars for satisfaction of charge thereof Form CHG-4

Notice of appointment or cessation of receiver or manager Form CHG-6
Application for registration of creation or modification of charge for
debentures or Form CHG-9 rectification of particulars filed in respect of creation
or modification of charge for debentures.

6.12 Key Concepts

Charging a security means that the borrower gives the lending bank a right
to (i) transfer the title from the borrower to the bank (ii) take possession of the
securities (iii) recover the dues through legal course.
Pledge means bailment of goods for the purpose of providing security for
payment of debt or performance of promise.
'A mortgage is the transfer of interest in specific immoveable 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 term Hypothecation means a charge created on any movable asset/
property, for a loan borrowed by the owner of goods/movable assets (existing or
future) without transferring, either the property or the possession to the lender.

6.13 Summary
l Banks should be careful while accepting various securities and ensure such
securities are properly charged (like lien, hypothecation, pledge, assignment,
set off and mortgages) in favour of the banks.
Banking Laws and
(92) Operations - I
l Pledge means bailment of goods for the purpose of providing security for Charge over Securities
payment of debt or performance of promise.
l The term "Hypothecation' means a charge created on any movable asset/
property, for a loan borrowed by the owner of goods/movable assets (existing
or future) without transferring, either the property or the possession to the NOTES
lender.
l The banker has general lien on all deposits.
l Assignment is a type of charge on certain securities offered to a creditor. It
is transfer of right, for a property or debt.
l Simple mortgage, Mortgage by conditional sale, Usufructuary mortgage,
English mortgage, Mortgage by deposit of title deeds (Equitable mortgage),
Anomalous mortgage.

6.14 Exercise
Fill in the blanks
1. A charge is a ______ created by any person including a company referred
to as "the borrower" on its assets and properties, present and future, in favour
of a financial institution or a bank, referred to as "the lender", which has
agreed to extend financial assistance.
(right, obligation, order)
2. In case of _____, a person whose goods are bailed is called pawnor or
pledger.
(Pledge, Hypothecation, Mortgage)
3. Pledge can be created only in the case of ________ (and not on future
goods) which are in the possession of the pledger himself.
(future goods, existing goods, virtual goods)
4. The charge in hypothecation is applicable to _______ assets.
(fixed, semi fixed, movable)
5. In case of _________-, possession of the goods/assets is held by the
borrower; hence, it is always difficult for the creditor (lender) to have control
over such goods.
(Hypothecation, Mortgage, Assignment)
6. Regarding hypothecation, In case the borrower is a Limited Company
registration of charge with _________ is a must.
(ROC, RBI, SBI)
7. Section 171 of the Indian Contract Act,1872 gives to the ______an absolute
right of general lien on all goods and securities received by the banker.
(Pledger, Pawnee, Banker)
8. ___________ is a type of charge on certain securities offered to a creditor.
It is transfer of right, for a property or debt.
(hypothecation, lien, Assignment)
9. In mortgage the instrument by which the transfer is effected is called the
'mortgage _______'.
(Deed, Paper, Document)
10. an '__________ Mortgage' is a transaction in which, the mortgagor binds
himself 'to repay the mortgage money on a certain date and transfers the
mortgaged property absolutely to the mortgagee, but subject to the provision Banking Laws and
Operations - I (93)
Banking Laws and that he will retransfer it to the mortgagor upon payment of the mortgage
Operations - I money as agreed'.
(English, Usufructuary, Equitable)
11. The limitation period for filing a suit for sale of mortgaged property is ______
NOTES years, from the date the mortgage debt becomes due.
(fifteen, twelve, thirty)

[ANS: 1)Right 2)Pledge 3)existing goods 4)movable 5)hypothecation

6)ROC 7)Banker 8)Assignment 9)Deed 10)English 11)twelve]

6.15 Further Readings & References

1. M.L.Tannan, revised by : Banking Law and Practice, Wadhwa & Company,
Nagpur C.R. Datta & S.K. Kataria
2. A.B. Srivastava and : Seth's Banking Law, Law Publisher's India (P) Limited
K. Elumalai
3. R.K. Gupta : BANKING Law and Practice in 3 Vols. Modern Law Publications.
4. Prof. Clifford Gomez : Banking and Finance - Theory, Law and Practice, PHI
Learning Private Limited
5. J.M. Holden : The Law and Practice of Banking, Universal Law Publishing.

Banking Laws and

(94) Operations - I
 Loans and Advances
UNIT 7
LOANS AND ADVANCES
Structure NOTES

7.0 Introduction
7.1 Objectives
7.2 Principles of Lending
7.3 Credit Worthiness of Borrowers
7.4 Collection of Credit Information
7.5 Types of Credit Facilities
7.6 Fund Based Credit Facilities
7.7 Non-Fund Based Facilities
7.8 Key Concepts CHECK YOUR
7.9 Summary PROGRESS
7.10 Exercise
Describe Principles of
7.11 Further Readings & References
Lending?

7.0 Introduction
Banks' main source of funds is deposits. These deposits are repayable on
demand or after a specific time. Hence, banks should deploy such funds very
carefully. Generally, banks use their funds for (i) loan assets and (ii) investments.
While deploying funds as loans and advances, banks should ensure that
certain lending principles are followed by them. Banks should give importance to
the principles of lending based on the following concepts: Safety, Liquidity, Purpose,
Diversity, Security and Profitability.
Banks should also ensure that a good credit monitoring system is in place
both at pre-sanction and post-sanction levels.

7.1 Objectives
After reading this unit, you should be able to:
- Understand various types of credit facilities granted by banks
- Legal frame work and regulatory applications in lending by banks
- Importance of priority sector lending to Agriculture, SMEs, Women
Entrepreneurs,etc.
- Deployment of funds to various loans and advances

7.2 Principles of Lending

The business of lending, which is main business of the banks, carry certain
inherent risks and bank cannot take more than calculated risk whenever it wants to
lend. Hence, lending activity has to necessarily adhere to certain principles. Lending
principles can be conveniently divided into two areas (i) activity, and (ii) individual.
(i) Activity:
(a) Principle of Safety of Funds Banking Laws and
Operations - I (95)
Banking Laws and (b) Principle of Profitability
Operations - I
(c) Principle of Liquidity
(d) Principle of Purpose
(e) Principle of Risk Spread
NOTES
(f) Principle of Security
(ii) Individual :
(a) Process of Lending
(b) 5 'C's of the borrower = Character, Capacity, Capital, Collateral,
Conditions Sources of information available to assess the borrower
- Loan application
- Market reports
- Operation in the account
- Report from other Bankers
- Financial statements, IT returns etc.
- Personal interview
- Unit inspection prior to sanction
(c) Security Appraisal Primary & collateral security should be 'MASTDAY'
M - Marketability
A - Easy to ascertain its title, value, quantity and quality.
S - Stability of value.
T - Transferability of title.
D - Durability - not perishable.
A - Absence of contingent liability. I.e. the bank may not have to spend
more money on the security to make it marketable or even to maintain
it.
Y - Yield. The security should provide some on-going income to the borrower/
bank to cover interest & or partial repayment.
The traditional principles of bank lending have been followed with certain
modifications. The concept of security has undergone a radical change and
profitability has been subordinated to social purpose in respect of certain types of
lending. Let us now discuss the principles of lending in details:
A. Safety
As the bank lends the funds entrusted to it by the depositors, the first and
foremost principle of lending is to ensure the safety of the funds lent. By safety is
meant that the borrower is in a position to repay the loan, along with interest,
according to the terms of the loan contract. The repayment of the loan depends
upon the borrower's (a) capacity to pay, and (2) willingness to pay. The former
depends upon his tangible assets and the success of his business; if he is successful
in his efforts, he earns profits and can repay the loan promptly. Otherwise, the loan
is recovered out of the sale proceeds of his tangible assets. The willingness to pay
depends upon the honesty and character of the borrower. The banker should,
therefore, taken utmost care in ensuring that the enterprise or business for which a
loan is sought is a sound one and the borrower is capable of carrying it out
successfully. He should be a person of integrity, good character and reputation. In
addition to the above, the banker generally relies on the security of tangible assets
owned by the borrower to ensure the safety of his funds.
B. Liquidity
Banking Laws and Banks are essentially intermediaries for short term funds. Therefore, they
(96) Operations - I
lend funds for short periods and mainly for working capital purposes. The loans Loans and Advances
are, therefore, largely payable on demand. The banker must ensure that the borrower
is able to repay the loan on demand or within a short period. This depends upon the
nature of assets owned by the borrower and pledged to the banker. For example,
goods and commodities are easily marketable while fixed assets like land and NOTES
buildings and specialized types of plant and equipment can be liquidated after a
time interval. Thus, the banker regards liquidity as important as safety of the funds
and grants loans on the security of assets which are easily marketable without
much loss.
C. Profitability
Commercial banks are profit-earning institutions; the nationalized banks
are no exception to this. They must employ their funds profitably so as to earn
sufficient income out of which to pay interest to the depositors, salaries to the staff
and to meet various other establishment expenses and distribute dividends to the
shareholders (the Government in case of nationalized banks). The rates of interest
charged by banks were in the past primarily dependent on the directives issued by
the Reserve Bank. Now banks are free to determine their own rates of interest on
advances. The variations in the rates of interest charged from different customers
depend upon the degree of risk involved in lending to them. A customer with high
reputation is charged the lower rate of interest as compared to an ordinary customer.
The sound principle of lending is not to sacrifice safety or liquidity for the sake of
higher profitability. That is to say that the banks should not grant advances to
unsound parties with doubtful repaying capacity, even if they are ready to pay a
very high rate of interest. Such advances ultimately prove to be irrecoverable to
the detriment of the interests of the bank and its depositors.
D. Purpose of the Loan
While lending his funds, the banker enquires from the borrower the purpose
for which he seeks the loan. Banks do not grant loans for each and every purpose-
they ensure the safety and liquidity of their funds by granting loans for productive
purposes only, viz., for meeting working capital needs of a business enterprise.
Loans are not advanced for speculative and unproductive purposes like social
functions and ceremonies or for pleasure trips or for the repayment of a prior loan.
Loans for capital expenditure for establishing business are of long-term nature and
the banks grant such term loans also. After the nationalization of major banks loans
for initial expenditure to start small trades, businesses, industries, etc., are also
given by the banks.
E. Principle of Diversification of Risks
This is also a cardinal principle of sound lending. A prudent banker always
tries to select the borrower very carefully and takes tangible assets as securities to
safeguard his interests. Tangible assets are no doubt valuable and the banker feels
safe while granting advances on the security of such assets, yet some risk is always
involved therein.
An industry or trade may face recessionary conditions and the price of the
goods and commodities may sharply fall. Natural calamities like floods and
earthquakes, and political disturbances in certain parts of the country may ruin
even a prosperous business. To safeguard his interest against such unforeseen
contingencies, the banker follows the principle of diversification of risks based on
the famous maxim "do not keep all the eggs in one basket."
It means that the banker should not grant advances to a few big firms only
or to concentrate them in a few industries or in a few cities or regions of the
country only. The advances, on the other hand, should be over a reasonably wide
area, distributed amongst a good number of customers belonging to different trades Banking Laws and
Operations - I (97)
Banking Laws and and industries. The banker, thus, diversifies the risk involved in lending. If a big
Operations - I customer meets misfortune, or certain trades or industries are affected adversely,
the overall position of the bank will not be in jeopardy.
F. Bank Credit, National Policy and Objectives
NOTES Banking institutions are amongst the commanding heights of an economy.
They must serve the national policy and objectives. Twenty major banks in India
were nationalized "to serve better the needs of development of the economy in
conformity with the national policy and objectives." Necessary changes in the
banking policies and practices were urgently necessitated in the wake of
nationalization to serve wider social purpose of established democratic socialism in
the country.
Significant changes have taken place in the concept of security observed
by the bankers in their attitude towards the hitherto weaker and neglected sections
of society during the last two decades. Banks have been directed to finance on a
large scale agriculturists, small industrialists, professional persons and transporters,
etc. Banks have also been asked to help in the implementation of the 20-Point
CHECK YOUR Programme and have been directed to ensure that banks' advances within the
PROGRESS priority sectors are given increasingly to the weaker and underprivileged sections
at concessional rate of interest. Security of funds lent is not sought exclusively in
Describe Credit the tangible assets of the borrower but also in his technical competence, managerial
Worthiness of ability, honesty and integrity. Loans are being given in large numbers for the setting
Borrowers? up of small businesses and for starting practice by professional persons. It is to be
noted that bank credit has to act as an important instrument for achieving wider
social purpose, national policies and objectives. However, the basic principles of
sound lending are fundamental and are observed even by the nationalized banks.
The ways in which the basic principles are followed, of course, may be modified to
suit the needs of the times.
Public Sector Banks are also required, under Section 8 of the Banking
Companies (Acquisition and Transfer of Undertakings) Act, 1970 in the discharge
of their functions, to be guided by such directions in regard to matters of policy
involving public interest as the Central Government give. The Central Government
and the Reserve Bank have issued a number of directions in this regard, highlighting
the social purpose which they have to sub serve.

7.3 Credit Worthiness of Borrowers

The business of sanctioning unsecured advances is comparatively more
risky and needs special care and attention on the part of the banker. In the absence
of a charge over any specific asset, the safety of advance depends upon the honesty
and integrity of the borrower as much as upon the worth of his tangible assets. The
banker has, therefore, to make proper enquiries not only about the borrower's
capacity to pay but also about his willingness to pay the amount. Though such
enquiry is also necessary in case of a secured advance but its urgency is greater in
case of an unsecured advance for obvious reasons. The creditworthiness of a
person means that he deserves a certain amount of credit, which may safely be
granted to him. Such creditworthiness is judged by the banker on the basis of his
(1) character, (2) capacity, and (3) capital.
1. Character:
In assessing the creditworthiness of a person, the first consideration is that
of the character of the person concerned. The word character implies and includes
a number of personal characteristics of a person, e.g., his honesty, integrity, regularity
Banking Laws and and promptness in fulfilling his promises and repaying his dues, sense of responsibility,
(98) Operations - I
good habits and the reputation and goodwill which he enjoys in the eyes of others. Loans and Advances
If a person possesses all these qualities, without any doubt or suspicion in the
minds of others, he possesses an excellent character and will be considered
creditworthy by the banker.
2. Capacity: NOTES
The success of an enterprise largely depends upon the ability, competence
and experience of the entrepreneur. If the borrower possesses necessary technical
skill, managerial ability and experience to run a particular industry or trade, success
of such unit may be taken for granted (barring some unforeseen circumstances)
and the banker will consider him a deserving case for granting an advance. The
significance of this factor is now growing as the banks are willing to grant unsecured
loans to technicians and competent persons on the basis of soundness of their
business projects, irrespective of their own capital.
3. Capital:
The importance attached by the banker to the adequacy of capital of the
borrower is not without significance. Banks are the repositories of the public money
CHECK YOUR
and lend the borrowed money. The banker, therefore, does not lend money to an
PROGRESS
entrepreneur who does not have adequate funds of his own. In case of failure of
the business enterprise, the banker will be able to realize his money if the borrower's
Describe Collection of
own capital is sufficient.
Credit Information?
Though all the above-mentioned factors are important and taken into
account by the banker at the time of assessing the creditworthiness of the borrower,
their relative importance differs from banker to banker and from borrower to
borrower. The consideration of security is now undergoing a change. Greater
emphasis is being laid on the ability and competence of the borrower and soundness
of his project. However, persons of doubtful integrity and without good character
are not granted unsecured advances. Further, creditworthiness is a relative term.
A person may be considered, on the basis of the above, creditworthy for a certain
amount only and not more.

7.4 Collection of Credit Information

The credit information is collected through the following sources:
1. Credit Information Bureau: The Reserve Bank of India has established
within itself a Credit Information Bureau which collects credit information
from the banks under Section 45-C (1) of the Reserve Bank of India
Act, 1934. Banks are required to furnish such credit information in
respect of credit limits of ' 5 lakhs and over in case of secured advances
and ' 1 lakh and over in case of unsecured advances. They mention the
nature of facility, security and charge along with outstanding balance.
After consolidating such information in respect of each customer, the
Reserve Bank supplies to the applicant-banks information relating to
the total limits sanctioned to and the number of banks dealing with a
party. Thus, the banks can find out if any of their customers is having
excessive borrowings from the banking system at any particular time.
Such information can be secured only in respect of big customers and
that too relating to the last Fridays of March, June, September and
December every year. Hence, the Bureau is of limited assistance to the
banks.
2. Borrower: Much information may be secured from the borrower directly.
The loan application form seeks basic information about the borrower
Banking Laws and
and his business. The banker may examine his account books and note
Operations - I (99)
Banking Laws and his past dealings with other banks or parties. His pass books with other
Operations - I banks can show his dealings and the business undertaken in the past. A
personal interview with the borrower will also enable the banker to get
a clear picture of his state of affairs.
NOTES 3. Bazar Reports: Banks try to find out the creditworthiness of the party
by making enquiries from the brokers, traders and businessmen in the
same trade or industry. Their individual opinions may differ but a balanced
opinion may be formed about the borrower on the basis of the feelings
expressed by a number of such persons.
4. Exchange of credit information amongst banks: It is the practice and
customary usage amongst banks to exchange credit information relating
to the constituents in their mutual interest. But the credit reports
exchanged by banks are brief and superficial. They are in general and
guarded terms. Banks are reluctant to exchange meaningful credit
information because they apprehend that legal protection available to
them will be lost if more facts are divulged to the enquiring banks. A
CHECK YOUR
study Group appointed to permit banks to exchange meaningful credit
PROGRESS
information on their constituents." The Study Group, therefore, suggested
that:
Describe Types of
(i) there should be free and frank exchange of credit information amongst
Credit Facilities?
the banks; and
(ii) there should be qualitative change in the contents of credit reports,
which should highlight the management practices of the customers, their
behavioural pattern with their buyers, sellers and with the bank instead
of concentrating entirely on the worth of assets and financial strength.
(iii) A central agency, to be called 'Credit Information Trust,' i.e., CREDIT
is established for organized collection, collation, storage and exchange
of credit information amongst the banks.
The Reserve Bank of India (Amendment) Act, 1974 inserted a clause
which provides statutory protection to banks to exchange freely credit
information, mutually amongst themselves. The scope of the term 'credit
information', has also been widened so as to include information relating
to the means, antecedents, history of financial transactions and the
creditworthiness of the borrowers.
5. Balance Sheet and Profit and Loss Account: An analysis of the Balance
Sheet and Profit and Loss Account of the borrower for the last few
years will reveal his true financial position. These statements should be
certified by competent accountants.

7.5 Types of Credit Facilities

The business of lending is carried on by banks offering various credit
facilities to its customers. Basically various credit facilities offered by banks are
generally repayable on demand. A bank should ensure proper recovery of funds
lent by him and acquaint itself with the nature of legal remedies available to it and
also law affecting the credit facilities provided by it.
Credit facilities broadly may be classified as under:
(a) Fund Based Credit Facilities
Fund based credit facilities involve outflow of funds meaning thereby the
money of the banker is lent to the customer. They can be generally of following
Banking Laws and types:
(100) Operations - I
 (i) Cash credits/overdrafts Loans and Advances
(ii) Demand Loans/Term loans
(iii) Bill finance
(b) Non-Fund Based Credit Facilities
NOTES
In this type of credit facility the banks funds are not lent to the customer
and they include:
(a) Bank Guarantees
(b) Letter of Credit

7.6 Fund Based Credit Facilities

1. Cash Credit
Cash credit is the main method of lending by banks in India and accounts
for about 70 per cent of total bank credit. CHECK YOUR
Under the system, the banker specifies a limit, called the cash credit limit, PROGRESS
for each customer, up to which the customer is permitted to borrow against the
security of tangible assets or guarantees. Cash credit is a flexible system of lending Describe Fund Based
under which the borrower has the option to withdraw the funds as and when Credit Facilities?
required and to the extent of his needs. Under this arrangement the banker specifies
a limit of loan for the customer (known as cash credit limit) up to which the customer
is allowed to draw. The cash credit limit is based on the borrower's need and as
agreed with the bank. Against the limit of cash credit, the borrower is permitted to
withdraw as and when he needs money subject to the limit sanctioned. It is normally
sanctioned for a period of one year and secured by the security of some tangible
assets or personal guarantee. If the account is running satisfactorily, the limit of
cash credit may be renewed by the bank at the end of year. The interest is calculated
and charged to the customer's account. Cash credit, is one of the types of bank
lending against security by way of pledge or /hypothecation of goods. 'Pledge'
means bailment of goods as security for payment of debt. Its primary purpose is to
put the goods pledged in the possession of the lender. It ensures recovery of loan in
case of failure of the borrower to repay the borrowed amount. In 'Hypothecation',
goods remain in the possession of the borrower, who binds himself under the
agreement to give possession of goods to the banker whenever the banker requires
him to do so. So hypothecation is a device to create a charge over the asset under
circumstances in which transfer of possession is either inconvenient or impracticable.
Other features of cash credit arrangements are as follows:
(1) The banker fixes the cash credit limit after taking into account several
features of working of the borrowing concern such as production, sales,
inventory levels, past utilization of such limits; etc. The banks are thus
inclined to relate the limits to the security offered by their customers.
(2) The advances sanctioned under the cash credit arrangement are
technically repayable on demand and there is no specific date of
repayment, but in practice they 'roll over' a period of time. Cash accruals
arising from the sales are adjusted in a cash credit account from time to
time but it is found that on a larger number of accounts no credit balance
emerges or debit balance fully wiped out over a period of years as the
withdrawals are in excess of receipts.
(3) Under the cash credit arrangement, a banker keeps adequate cash
balances so as to meet the demand of his customers as and when it
arises. But the customer is charged interest only on the actual amount
Banking Laws and
utilized by him. To neutralize the loss of interest on the idle funds kept by Operations - I (101)
Banking Laws and the banks within the credit limits sanctioned, a commitment charge on
Operations - I the unutilized limits may be charged by the banks.
(4) The Reserve Bank has advised the banks to evolve their own guidelines
to ensure credit discipline and levy a commitment charge. Thus the
NOTES commitment charge depends upon the discretion of individual banks.
Advantages
1. Flexibility: The borrowers need not keep their surplus funds idle with
themselves, they can recycle the funds quite efficiently and can minimize
interest charges by depositing all cash accruals in the bank account and
thus ensures lesser cost of funds to the borrowers and better turnover
of funds for the banks.
2. Operative convenience: Banks have to maintain one account for all the
transactions of a customer. The repetitive documentation can be avoided.
Disadvantages
1. Fixation of Credit Limits: The cash limits are prescribed once in a year.
Hence it gives rise to the practice of fixing large limits than is required
for most part of the year. The borrowers misutilise the unutilized gap in
times of credit restraint.
2. Bank's inability to verify the end-use of funds: Under this system the
stress is on security aspect.
Hence there is no conscious effort on the part of banks to verify the
end-use of funds. Funds are diverted, without banker's knowledge, to
unapproved purposes.
3. Lack of proper management of funds: Under this system the level of
advances in a bank is determined not by how much the banker can lend
at a particular time but by the borrower's decision to borrow at the time.
The system, therefore, does not encourage proper management of funds
by banks.
These weaknesses of the cash credit system were highlighted by a
number of committees appointed for this purpose in India. Guidelines
have been issued by the Reserve Bank for reforming the cash credit
system on the basis of recommendations of the Tandon Committee and
the Chore Committee.

2. Overdrafts
When a customer is maintaining a current account, a facility is allowed by
the bank to draw more than the credit balance in the account; such facility is called
an 'overdraft' facility. At the request and requirement of customers temporary
overdrafts are also allowed. However, against certain securities, regular overdraft
limits are sanctioned.
Salient features of this type of account are as under:
(i) All rules applicable to current account are applicable to overdraft accounts
mutatis mutandis.
(ii) Overdraft is a running account and hence debits and credits are freely
allowed.
(iii) Interest is applied on daily product basis and debited to the account on
monthly basis. In case of temporary overdraft, interest should be applied
as and when temporary overdraft is adjusted or at the end of the month,
whichever is earlier.
Banking Laws and (iv) Overdrafts are generally granted against the security of government
(102) Operations - I
 securities, shares & debentures, National Savings Certificates, LIC Loans and Advances
policies and bank's own deposits etc. and also on unsecured basis.
(v) When a current account holder is permitted by the banker to draw more
than what stands to his credit, such an advance is called an overdraft.
The banker may take some collateral security or may grant such advance NOTES
on the personal security of the borrower. The customer is permitted to
withdraw the amount as and when he needs it and to repay it by means
of deposit in his account as and when it is feasible for him. Interest is
charged on the exact amount overdrawn by the customer and for the
period of its actual utilization.
(vi) Generally an overdraft facility is given by a bank on the basis of a
written application and a promissory note signed by the customer. In
such cases an express contract comes into existence. In some cases, in
the absence of an express contract to grant overdraft, such an agreement
can be inferred from the course of business. For example, if an account-
holder, even without any express grant of an overdraft facility, overdraws
on his account and his cheque is duly honoured by the bank, the
transaction amounts to a loan. In Bank of Maharashtra v. M/s. United
Construction Co. and Others (AIR 1985 Bombay 432), the High Court
concluded that there was an implied agreement for grant of overdraft or
loan facility.
(vii) Banks should, therefore, obtain a letter and a promissory note
incorporating the terms and conditions of the facility including the rate
of interest chargeable in respect of the overdraft facility. This is to be
complied with even when the overdraft facility might be temporary in
nature.
Overdraft facility is more or less similar to 'cash credit' facility. Overdraft
facility is the result of an agreement with the bank by which a current account
holder is allowed to draw over and above the credit balance in his/her account.
It is a short-period facility. This facility is made available to current account
holders who operate their account through cheques. The customer is permitted to
withdraw the amount of overdraft allowed as and when he/she needs it and to
repay it through deposits in the account as and when it is convenient to him/her.
Overdraft facility is generally granted by a bank on the basis of a written request
by the customer. Sometimes the bank also insists on either a promissory note from
the borrower or personal security of the borrower to ensure safety of amount
withdrawn by the customer. The interest rate on overdraft is higher than is charged
on loan.

3. Bills Finance
In order to ease the pressures on cash flow and facilitate smooth running
of business, Bank provides Bill finance facility to its corporate / non corporate
clients. Bill finance facility plugs in the mismatches in the cash flow and relieves
the corporates from worries on commitments. Besides the fund based bill finance,
we also provide agency services for collection of documentary bills/cheques. Under
bills finance mechanism a seller of goods draws a bill of exchange (draft) on buyer
(drawee), as per payment terms for the goods supplied. Such bills can be routed
through the banker of the seller to the banker of the buyer for effective control.
(i) Clean & Documentary bill :
(a) When documents to title to goods are not enclosed with the bill, such a
bill is called Clean Bill. When documents to title to goods along with other documents
are attached to the bill, such a bill is called 'Documentary Bill'. Banking Laws and
Operations - I (103)
Banking Laws and (b) Documents, the due possession of which give title to the goods covered
Operations - I by them such as RR/MTR, bill of lading, delivery orders etc. are called documents
to title to goods.
(c) Cheques and drafts are also examples of clean bills.
NOTES (ii) Demand & Usance bill :
When the bill of exchange either clean or documentary is made payable
on demand or sight, such a bill is called Demand Bill. The buyer is expected to pay
the amount of such bill immediately at sight. If such a demand bill is a documentary
bill, then the documents including document to title to goods are delivered to the
buyer only against payment of the bill. (Documents against Payment-D/P Bills).
When a bill, either clean or documentary is drawn payable after certain
period or on a specified date, the bill is called Usance Bill. Such bill is presented to
the buyer once for Acceptance, when he accepts to pay the bill on due date and on
due date the bill is presented again for Payment. In case of documentary usance
bill, the documents are delivered to the buyer (drawee/acceptor) against his
acceptance of bill (Documents against acceptance - DA Bills).
CHECK YOUR
PROGRESS 4. Term Loans
The loan is disbursed by way of single debit/stage-wise debits (wherever
Describe term loans?
sanction so accorded) to the account. The amount may be allowed to be repaid in
lump sum or in suitable installments, as per terms of sanction. Loan is categorized
Demand Loan if the repayment period of the loan is less than three years, in case
the repayment of the loan is three years and above the loan be considered as Term
Loan.
Under the loan system, credit is given for a definite purpose and for a
predetermined period. Normally, these loans are repayable in installments. Funds
are required for single non-repetitive transactions and are withdrawn only once. If
the borrower needs funds again or wants renewal of an existing loan, a fresh
request is made to the bank.
Thus, a borrower is required to negotiate every time he is taking a new
loan or renewing an existing loan. Banker is at liberty to grant or refuse such a
request depending upon his own cash resources and the credit policy of the central
bank.
Advantages of Loan System
1. Financial Discipline on the borrower: As the time of repayment of the
loan or its installments is fixed in advance, this system ensures a greater
degree of self-discipline on the borrower as compared to the cash credit
system.
2. Periodic Review of Loan Account: Whenever any loan is granted or its
renewal is sanctioned, the banker gets as opportunity of automatically
reviewing the loan account. Unsatisfactory loan accounts may be
discontinued at the discretion of the banker.
3. Profitably: The system is comparatively simple. Interest accrues to the
bank on the entire amount lent to a customer.
Drawbacks
1. Inflexibility: Every time a loan is required, it is to be negotiated with the
banker. To avoid it, borrowers may borrow in excess of their exact
requirements to provide for any contingency.
2. Banks have no control over the use of funds borrowed by the customer.
However, banks insist on hypothecation of the asset/ vehicle purchased
Banking Laws and
(104) Operations - I
with loan amount.
 3. Though the loans are for fixed periods, but in practice the roll over, i.e., Loans and Advances
they are renewed frequently.
4. Loan documentation is more comprehensive as compared to cash credit
system.
Types of Term Loans: NOTES
Term loans are granted by banks to borrowers for purchase of fixed assets
like land and building, factory premises, embedded machinery etc., to enable their
manufacturing activities, and their business expansion, if the amounts are repayable
after a specific period of time, they are all called as term finance. On the basis of
the period for which the funds are required by the borrowers, these loans are
classified as short, medium and long term loans.
Banks have been given freedom to fix their own interest rate for loans and
advances. As per bank's lending and interest rate policies applicable interest and
other charges would be applicable to CC, OD, Term loan accounts.
Each bank should decide "base rate" of interest on advances as per RBI
CHECK YOUR
directives.
PROGRESS
Short Term Medium Term Long Term
1-3 Years 3-5 Years Above 5 Years Describe Types of
Loans which are repayable within 1 - 3 years are classified as Short term,
Term Loans?
3-5 years are classified as Medium Term and above 5 years are classified as long
term.
Term Loans - Important aspects:
1. Term loans are given to the manufacturing, trading and service sector
units which require funds for purchasing various items of fixed assets,
such as, land and building, plant and machinery, electrical installation
and other preliminary and pre-operative expenses.
2. Repayment of term loans would depend upon the firm's capacity to
produce goods or services by using the fixed assets as financed by
banks.
3. Like any other loan, a term loan is sanctioned by the bank, after evaluation
of credit proposal (application). The bank before granting terms loans
needs to carry out a clear due diligence as to the borrower's requirement,
capacity and other aspects.
4. While considering a term loan proposal, the bank need to verify the
financial status, economic viability and the firm's production capacity.
5. After proper verification and satisfaction of various requirements, banks
can grant a term loan, on certain terms and conditions, covenants, including
repayment terms.
6. Term loans like any other credit facility needs to cover Six C concepts
and the banks should follow bank's lending policy, exposure norms and
the RBI's guidelines and directives
7. All required valid collateral security, duly executed should be one of the
pre conditions for the loan amount to be disbursed.
8. The assets created out of the bank loan, are charged depending upon
the nature of security (hypothecation, mortgage, etc.
9. At the time of fixing the limit and quantum of finance, a banker is required
to make assessment of actual cost of assets to be acquired, margin to
be contributed, sources of repayment, etc.
Banking Laws and
Operations - I (105)
Banking Laws and A legal case decided by High Court in respect of term loans is given below:
Operations - I
Bridge Loans
Bridge loans are essentially short term loans which are granted to industrial
undertakings to meet their urgent and essential needs during the period when
NOTES formalities for availing of the term loans sanctioned by financial institutions are
being fulfilled or necessary steps are being taken to raise the funds from the capital
market. These loans are granted by banks or by financial institutions themselves
and are automatically repaid out of amount of the term loan or the funds raised in
the capital market.
In April, 1995, Reserve Bank of India banned bridge loans granted by
banks and financial institutions to all companies. But in October, 1995, Reserve
Bank of permitted the banks to sanction bridge loans/interim finance against
commitment made by a financial institutions or another bank where the lending
institution faces temporary liquidity constraint subject to the following conditions:
(i) The prior consent of the other bank/financial institution which has
sanctioned a term loan must be obtained.
CHECK YOUR
(ii) The term lending bank/financial institution must give a commitment to
PROGRESS
remit the amount of the term loan to the bank concerned.
Describe Non-Fund (iii) The period of such bridge loan should not exceed four months.
Based Facilities (iv) No extension of time for repayment of bridge loan will be allowed.
(v) To ensure that bridge loan sanctioned is utilized for the purpose for
which the term loan has been sanctioned.

In November, 1997, Reserve Bank permitted the banks to grant bridge

loans to companies (other than non- banking finance companies) against public
issue of equity in India or abroad. The guidelines for sanction of such loans are to
be laid down by each bank and should include the following aspects:
(i) Security to be obtained for the loan.
(ii) The quantum of outstanding bridge loan (or the limit sanctioned, whichever
is higher) during the year.
(iii) Compliance with individual/group exposure norms.
(iv) Ensuring end use of bridge loan.
(v) The maximum period of the bridge loan to be one year.
Composite Loans
When a loan is granted both for buying capital assets and for working
capital purposes, it is called a composite loan. Such loans are usually granted to
small borrowers, such as artisans, farmers, small industries, etc.
Consumption Loans
Though normally banks provide loans for productive purposes only but as
an exception loans are also granted on a limited scale to meet the medical needs or
the educational expenses or expenses relating to marriages and other social
ceremonies etc. of the needy persons. Such loans are called consumption loans.

7.7 Non-Fund Based Facilities

In the business of lending, a banker also extends non-fund based facilities.
Non-fund based facilities do not involve immediate outflow of funds. The banker
undertakes a risk to pay the amounts on happening of a contingency. Nonbiased
Banking Laws and facilities can be of following types among other:
(106) Operations - I
 (a) Bank Guarantees Loans and Advances
(b) Letter of Credit
(c) Underwriting and credit guarantee
(A) Bank Guarantee
NOTES
As part of Non-fund based facilities, banks issue guarantees on behalf of
their clients. A Bank Guarantee is a commitment given by a banker to a third party,
assuring her/ him to honour the claim against the guarantee in the event of the non-
performance by the bank's customer. A Bank Guarantee is a legal contract which
can be imposed by law. The banker as guarantor assures the third party (beneficiary)
to pay him a certain sum of money on behalf of his customer, in case the customer
fails to fulfill his commitment to the beneficiary.
Types of Guarantee
Banks issue different types of guarantees, on behalf of their customers, as
illustrated below:
Financial
Performance
Deferred Payment

(1) Financial Guarantee:

The banker issues guarantee in favour of a government department against
caution deposit or earnest money to be deposited by bank's client. At the request of
his customer, in lieu of a caution deposit/ earnest money, the banker issues a guarantee
in favour of the government department. This is an example of a Financial
Guarantee. This type of guarantee helps the bank's customer to bid for the contract
without depositing actual money. In case, the contractor does not take up the
awarded contract, then the government department would invoke the guarantee
and claim the money from the bank.

(2) Performance Guarantee:

Performance Guarantees are issued by banks on behalf of their clients.
For example:
XYZ Ltd, the Indian engineering company undertakes an overseas project.
The project is to construct highways in one of the African nations. XYZ Ltd,
required to furnish a bank guarantee. Since the company has undertaken an overseas
project, the company is called as project exporter. XYZ Ltd approaches his banker
to issue a bank guarantee in favour of the African nation to whom the company is
going to construct the highways. XYS's bank issues a bank guarantee and it will be
a performance guarantee. Bank as guarantor guarantees the beneficiary that in
case the project exporter (XYZ company) does not perform to the satisfaction of
the beneficiary, then within the validity period (including the claim period if any) of
the guarantee, the beneficiary can invoke the guarantee and the banker has to
honour his commitment and pay the amount mentioned in the guarantee. There are
three parties in a guarantee:
(a) (Applicant)
(b) (Beneficiary) and
(c) the Banker (guarantor)
(3) Deferred Payment Guarantee:
Under this guarantee, the banker guarantees payments of installments
spread over a period of time. Banking Laws and
Operations - I (107)
Banking Laws and For example:
Operations - I
A purchases a machinery on a long-term credit basis and agrees to pay in
installments on specified dates over a period of time. In terms of the contract of
sale, B (the seller) draws Bills of Exchange on the customer for different maturities.
NOTES These bills are accepted by A. The banker (guarantor) guarantees payment of
these bills of exchange on the due date. In the event of default by A, the banker
need to honour the claim to the seller (beneficiary).
Bank Guarantee - Some Important Features:
- Bank's obligation to pay is primary
- Banker's commitment to honour the claim is primary, even if there is any
dispute between the beneficiary and the debtor
- Banker needs to honour the claim, irrespective of the customer's balance
in the bank account
- Except in case of frauds, in other cases, the banker cannot refuse
payments, when a claim is received within a stipulated time. Courts also have
refused to grant injunctions against banks from making payment under the guarantee,
except in cases of frauds
Bank Guarantee: Precautions
The liability of the bank under a guarantee depends on:
(i) the amount of the guarantee and (ii) the period of the guarantee
These two are important factors to be clearly mentioned in the guarantee
issued by the banker, otherwise the bank's liability could be unlimited. The bank
should obtain a counter guarantee from the customer on whose behalf guarantee is
issued. At the time of issuing the guarantee, the amount to be paid under the
guarantee should clearly state whether the amount is inclusive of all interest charges,
taxes and other levies to avoid disputes regarding the liability of the bank.
On invocation (claim made by the beneficiary), the bank is liable to pay the
entire amount of the guarantee unless in case of a fraud. The bank should specifically
indicate the period for which the guarantee is valid. The guarantee should also
indicate the claim period, usually beyond the validity period. Further in case of
invocation, the banker is required to ensure that: (a) invocation is made within the
validity period (b) the amount is not more than the guaranteed amount (c) the
person invoking has powers to invoke the guarantee.
(B) Letters of Credit
A Letter of Credit is issued by a bank at the request of its customer (importer)
in favour of the beneficiary (exporter). It is an undertaking/ commitment by the
bank, advising/informing the beneficiary that the documents under a LC would be
honoured, if the beneficiary (exporter) submits all the required documents as per
the terms and conditions of the LC.
Importance of letter of credit in trade activities
The trade can be classified into Inland and International. Due to the
geographical proximities of the importers and the exporters, banks are involved in
LC transactions to avoid default in payment (credit risks). To facilitate trade and
also to enable the exporter and importer to receive and pay for the goods sold and
bought, letter of credit is used as a tool. Letter of credit mechanism that the payment
and receipts (across the globe) are carried out in an effective manner
Parties to Letters of Credit
1. Applicant (importer) requests the bank to issue the LC
2. Issuing bank (importer's bank which issues the LC [also known as
Banking Laws and Opening banker of LC])
(108) Operations - I
 3. Beneficiary (exporter) Different types of banks: Loans and Advances
- Opening bank (a bank which issues the LC at the request of its customer
[importer])
- Advising bank (the issuing banker's correspondent who advices the
LC to beneficiary's banker and/ or beneficiary) NOTES
- Negotiating bank (the exporter's bank, which handles the documents
submitted by the exporter. The bank also finances the exporter against
the documents submitted under a LC)
- Confirming bank (the bank that confirms the credit)
- Reimbursing bank (reimburses the LC amount to the negotiating/
confirming bank)
Types of LC
(a) Sight Credit - Under this LC, documents are payable at sight/ upon
presentation
(b) Acceptance Credit/ Time Credit - The Bills of Exchange which are
drawn, payable after a period, are called usance bills. Under acceptance
credit usance bills are accepted upon presentation and eventually
honoured on due dates.
(c) Revocable and Irrevocable Credit - A revocable LC is a credit, the
terms and conditions of the credit can be amended/ cancelled by the
Issuing bank, without prior notice to the beneficiaries. An irrevocable
credit is a credit, the terms and conditions of which can neither be
amended nor cancelled without the consent of the beneficiary. Hence,
the opening bank is bound by the commitments given in the LC.
(d) Confirmed Credit - Only Irrevocable LC can be confirmed. A confirmed
LC is one when a banker other than the Issuing bank, adds its own
confirmation to the credit. In case of confirmed LCs, the beneficiary's
bank would submit the documents to the confirming banker.
(e) Back-to-Back credit - In a back to back credit, the exporter (the
beneficiary) requests his banker to issue a LC in favour of his supplier
to procure raw materials, goods on the basis of the export LC received
by him. This type of LC is known as Back-to-Back credit.
Example: An Indian exporter receives an export LC from his overseas
client in Netherlands. The Indian exporter approaches his banker with a
request to issue a LC in favour of his local supplier of raw materials.
The bank issues a LC backed by the export LC.
(f) Transferable Credit - While a LC is not a negotiable instrument, the
Bills of Exchange drawn under it are negotiable. A Transferable Credit
is one in which a beneficiary can transfer his rights to third parties. Such
LC should clearly indicate that it is a 'Transferable' LC
(g) "Red Clause" Credit & "Green Clause" Credit - In a LC a special clause
allows the beneficiary (exporter) to avail of a pre-shipment advance (a
type of export finance granted to an exporter, prior to the export of
goods). This special clause used to be printed (highlighted in red colour,
hence it is called "Red Clause" Credit. The issuing bank undertakes to
repay such advances, even if shipment does not take place. In case of a
'Green clause' credit, the exporter is entitled for an advance for storage
(warehouse) facilities of goods. The advance would be granted only
when the goods to be shipped have been warehoused, and against an
undertaking by the exporter that the transportation documents would be
delivered by an agreement date. Banking Laws and
Operations - I (109)
Banking Laws and (h) Standby LC: In certain countries there are restrictions to issue
Operations - I guarantees, as a substitute these countries use standby credit. In case
the guaranteed service is not provided, the beneficiary can claim under
the terms of the standby credit. In case of Standby LCs, the documents
NOTES required are proof of non-performance or a simple claim form.

Documents handled under Letters of Credit

Documents play a crucial role in trade transactions. Documents are integral
part of LCs. The banks involved in LC transactions deal only with documents and
on the evidence of the correct and proper documents only the paying banks (opening
bank/confirming bank) need to make payment. In view of these factors, banks
have to be careful while handling documents/ LCs.
At various stages, different banks (Negotiating bank {beneficiary's bank},
confirming bank, opening bank) have to verify whether all the required documents
are submitted strictly as per the terms and conditions of credit. The important
documents handled under LCs are broadly classified as
(a) Bill of Exchange:
Bill of exchange, is drawn by the beneficiary (exporter) on the LC issuing
bank. When the bill of exchange is not drawn under a LC, the drawer of the bill of
exchange (exporter), draws the bill of exchange on the drawee (importer).
In such a case, the exporter takes credit risk on the importer, whereas,
when the Bill of Exchange is drawn under LC, the credit risk for the exporter is not
on the importer but on the LC issuing bank. Banks should be careful in ensuring
that the Bill of Exchange is drawn strictly as per the terms and conditions of the
credit. Some others important aspects are:
(i) It should be drawn by the beneficiary on the opening bank (ii) It should
clearly indicate the amount and other details (iii) Depending upon the LC terms a
Bill of Exchange may be drawn as a sight bill or an usance bill (iv) It should clearly
indicate the LC number.
(b) Commercial Invoice:
This is another important document. Commercial invoice is prepared by
the beneficiary, which contains (i) relevant details about goods in terms of value,
quantity, weights (gross/net), importer's name and address, LC number (ii)
Commercial invoice should exactly reflect the description of the goods as mentioned
in LC. (iii) Another important requirement is that the commercial invoice should
indicate the terms of sale contract (Inco terms) like FOB, C&F, CIF, etc (iv) Other
required details like shipping marks, and any specific detail as per the LC terms
should also be covered.
(c) Transport Documents:
When goods are shipped from one port to another port the transport
document issued is called the bill of lading. Goods can be transported by means of
airways, roadways and railways depending upon the situations. In case goods are
transported by means of water ways, the document is called bill of lading, by
airways it is known as airway bills and by roadways called as lorry receipt and by
railways it is known as railway receipt. In case of a single transaction, when different
modes are used to transport the goods from the beneficiary's country to the
importer's destination, a single transport document can be used viz., Multi model
transport document. For ease of reference the most commonly used document
i.e., Bill of Lading is discussed here.
(d) Bill of Lading (B/ L):
Banking Laws and The B/ L is the shipment document, evidencing the movement of goods
(110) Operations - I
from the port of acceptance (in exporter's country) to the port of destination (in Loans and Advances
importer's country). It is a receipt, signed and issued by the shipping company or
authorized agent. It should be issued in sets (as per the terms of credit).
Other important features:
As per the terms and conditions of the credit, a bill of lading should clearly indicate: NOTES
(i) the description of goods shipped, as indicated in the invoice
(ii) conditions of goods "Clean" or otherwise (not in good condition/ shortage/
damaged)
(iii) drawn to the order of the shipper, blank endorsed or in favour of the
opening bank
(iv) the gross and net weight
(v) Freight payable or prepaid
(vi) Port of acceptance and port of destination

Insurance Policy/ Certificate: This document is classified as a document to cover

risk.
(a) It must be issued by the insurance company or their authorized agents
(b) It should be issued in the same currency in which the LC has been
issued
(c) It should be issued to cover "All Risks"
(d) The date of issuance of the policy/ certificate should be on or before the
date of issuance of the shipment, and should clearly indicate that the
cover is available from the date of shipment
(e) Unless otherwise specified, it should be issued for an amount of 110%
of CIF value of goods
(f) The description of the goods in the policy/certificate should be as per
the terms of the credit
(g) The other important details like the port of shipment, port of destination
etc needs to be clearly indicated.

7.8 Key Concepts

Loan is categorized Demand Loan if the repayment period of the loan is
less than three years, in case the repayment of the loan is three years and above
the loan be considered as Term Loan.
A Bank Guarantee is a commitment given by a banker to a third party,
assuring her/ him to honour the claim against the guarantee in the event of the non-
performance by the bank's customer.
A Letter of Credit is issued by a bank at the request of its customer (importer)
in favour of the beneficiary (exporter).

7.9 Summary
Loans and advances are the important segment of the deployment of funds
of a bank.
l The major activity of the banker as a lending banker calls for many precautions
to be exercised by the banker in dealing with different types of borrowers
and extending them various credit facilities. Banking Laws and
Operations - I (111)
Banking Laws and l Banker as a trustee of public funds is required to be careful in deploying the
Operations - I funds which have been accepted as deposits from depositors.
l Lending principles can be conveniently divided into two areas (i) activity, and
(ii) individual.
NOTES l As the bank lends the funds entrusted to it by the depositors, the first and
foremost principle of lending is to ensure the safety of the funds lent.
l The banker must ensure that the borrower is able to repay the loan on demand
or within a short period.
l The sound principle of lending is not to sacrifice safety or liquidity for the
sake of higher profitability.
l To safeguard his interest against such unforeseen contingencies, the banker
follows the principle of diversification of risks based on the famous maxim
"do not keep all the eggs in one basket."
l Twenty major banks in India were nationalized "to serve better the needs of
development of the economy in conformity with the national policy and
objectives."
l The creditworthiness of a person means that he deserves a certain amount
of credit, which may safely be granted to him.
l Cash credit is the main method of lending by banks in India and accounts for
about 70 per cent of total bank credit. Under the system, the banker specifies
a limit, called the cash credit limit, for each customer, up to which the customer
is permitted to borrow against the security of tangible assets or guarantees.
l When a customer is maintaining a current account, a facility is allowed by
the bank to draw more than the credit balance in the account; such facility is
called an 'overdraft' facility.
l Bill finance facility plugs in the mismatches in the cash flow and relieves the
corporates from worries on commitments. Besides the fund based bill finance,
we also provide agency services for collection of documentary bills/cheques.
l When a bill, either clean or documentary is drawn payable after certain
period or on a specified date, the bill is called Usance Bill.

7.10 Exercise
Fill in the blanks
1. Lending principles can be conveniently divided into two areas activity and
individual.
(individual, group, cumulative)
2. Banks lend funds for short periods and mainly for working capital purposes.
The loans are, therefore, largely payable on demand.
(Order, Request, Demand)
3. The rates of interest charged by banks were in the past primarily dependent
on the directives issued by the ________.
(RBI, Govt. Of India, Parliament)
4. Banks do not grant loans for each and every purpose-they ensure the safety
and liquidity of their funds by granting loans for productive purposes only.
(productive, generative, important)
5. To safeguard his interest against such unforeseen contingencies, the banker
follows the principle of diversification of risks based on the famous maxim
Banking Laws and "do not keep all the eggs in one basket."
(112) Operations - I
 (integration, diversification, conversion) Loans and Advances
6. In the absence of a charge over any specific asset, the safety of advance
given by the bank depends upon the honesty and integrity of the borrower as
much as upon the worth of his tangible assets and is known as Credit
worthiness of the borrower. NOTES
(credit worthiness, honesty, sincerity)
7. Cash credits/overdrafts, Demand Loans/Term loans, Bill finance are the
examples of ________ Credit Facilities.
(fund based, non fund based, cash based)
8. Bank Guarantees and Letter of credit are the type of __________ credit
facilities.
(fund based, non fund based, cash based)
9. Under the system of Cash Credit the banker specifies a limit, called the
_________, for each customer, up to which the customer is permitted to
borrow against the security of tangible assets or guarantees.
(cash credit limit, loan credit limit, borrowing credit limit)
10. When a customer is maintaining a current account, a facility is allowed by
the bank to draw more than the credit balance in the account; such facility is
called an _________ facility.
(Overdraft, Loan, Borrowing)

[ANS: 1)Individual, 2) Demand 3)RBI 4)Productive 5)Diversification

6)Credit worthiness 7) Fund based 8) Non fund based 9)Cash credit limit
10)Overdraft ]

7.11 Further Readings & References

1. M.L.Tannan, revised by : Banking Law and Practice, Wadhwa & Company,
Nagpur C.R. Datta & S.K. Kataria
2. A.B. Srivastava and : Seth's Banking Law, Law Publisher's India (P) Limited
K. Elumalai
3. R.K. Gupta : BANKING Law and Practice in 3 Vols.Modern Law Publications.
4. Prof. Clifford Gomez : Banking and Finance - Theory, Law and Practice, PHI
Learning Private Limited
5. J.M. Holden : The Law and Practice of Banking, Universal Law Publishing.

Banking Laws and

Operations - I (113)
Banking Laws and
Operations - I UNIT 8
FINANCIAL ANALYSIS OF BANKS
NOTES Structure
8.0 Introduction
8.1 Objective
8.2 Financial Analysis
8.3 Financial Statements (Balance Sheet & P & L Account)
8.3.1 Advantages of analysis of financial statements
8.3.2 Limitations of financial statements
8.3.3 Analysis of Profit & Loss A/c
8.3.4 Analysis of Balance Sheet
8.4 Analysis of Cash Flow and Fund Flow Statements
8.5 Financial Analysis Techniques
8.5.1 Fund Flow Analysis
8.5.2 Ratio Analysis
8.5.3 Trend Analysis
8.5.4 Du Pont Analysis
8.6 Special issues in financial analysis - Banking Industry
8.7 Financial analysis by bank as lender
8.8 Banker as Investor
8.9 Key concepts
8.10 Summary
8.11 Exercise
8.12 Further Readings & References

8.0 Introduction
Banks accept deposits from their depositors which form the main source
of funds for banks.
Banks also raise funds from the domestic and international financial
markets. These funds are deployed by banks as loans, advances and investments.
Hence, the banker at the time of deploying his funds acts either as a lending banker
or an investing banker and it needs to be careful.
Like any other lender and / or as an investor, a banker also needs to carry
out many a type of analysis.

8.1 Objectives
After studying this chapter, the student would be able to:
- Understand the types of financial statements and their role in financial
analysis
- Appreciate the various aspects of financial analysis and their significance
- Know why financial analysis is an important tool for lending and investing
Banking Laws and bankers
(114) Operations - I
 Financial analysis
8.2 Financial Analysis of Banks

Financial analysis is an assessment of the viability, stability and profitability

of unit, project or company. A careful analysis of the financial data has a great
NOTES
importance in the process of decision making by banks as it is based upon the
concrete results of the company's strategy and structure. Financial analysis assists
in determining a company's performance, health and stability using its balance
sheet, profit and loss (P&L) account, cash flow statement etc.
The performance of a company or business enterprise can be measured
by looking into the financial results of the company over a period of time. A
comparative study of the financial statements assists the analyst in assessing the
results. Two important financial statements commonly used for financial analysis
are P & L account, and balance sheet.
The financial statements are analyzed and interpreted by different classes
of persons, such as individual and institutional investors, bankers, financial institutions,
credit analysts, credit rating agencies, research, management students and CHECK YOUR
institutional investors. PROGRESS

What is Financial
8.3 Financial Statements (Balance Sheet & P & L A/c) Analysis?
(i) The balance sheet shows the financial position of the business as at the
end of a particular period (month, quarter or year). It shows the asset
and liability position for a company on a particular date on which the
balance sheet was drawn.
(ii) The profit and loss account shows the financial results of the working of
an enterprise over a period of time. For example, 1st of April 2012 to
31st March 2013. This statement shows the profit or loss of the company
during the span of the period covered.
(iii) A comparative analysis of these statements for a number of years gives
a better view about the financial performance of the business unit over
a period of time. This indicates growth or decline of past performance
usually termed as trend analysis.
(iv) Financial analysis and interpretation of financial statements have now
become important decision making tools, and is successfully used by
banks, entrepreneurs, consultants and auditors. In developed countries
even the investors carryout such analysis before putting in their fund.

8.3.1 Advantages of analysis of financial statements:

(a) The financial results in the form of P&L accounts and balance sheets
are readily available. Further, there are statutory requirements regarding
the certification of these statements which increase the credibility of
financial statements. Statutory requirement for the companies, in case
of Pvt. Limited Company and limited companies getting it Certified is
also compulsory as such these financial statements are true and accurate
and provides genuine result when analysed.
(b) These financial statements are drawn as per the accounting standards
and as per the regulatory and legal frame work. Thus, these statements
provide a homogenous presentation which makes the analysis
comparable.
(c) Depending upon the requirement of the analyst (investors, bankers, credit Banking Laws and
Operations - I (115)
Banking Laws and rating agencies etc.) the figures and data available on these statements
Operations - I can be easily grouped and interpreted.
(d) The financial statements can be used for ratio analysis, trend analysis
etc.
NOTES

8.3.2 Limitations of financial statements

(i) The balance sheet numbers are available as at a particular date hence
may not reveal the correct position of the financial health for over a
period of year.
(ii) Since both profit and loss account and balance sheet are in the form of
numerical statements, these statements may not reveal the overall picture
about the performance of the concern or business unit. This means the
productivity, moral status; motivated management and staff are not
indicated. Also to cover it a management audit is carried out
CHECK YOUR independently.
PROGRESS
(iii) The methods of valuation of assets, writing off depreciation, amortization
of costs, large expenses etc. may vary from one business unit to another.
Describe Limitations Therefore, a comparison of these numbers and ratios may not give
of financial desired results and calls for further detailed investigations.
statements? (iv) Further, these financial statements depict the performance of the business
enterprise. Therefore, any meaningful interpretation of these statements,
will depend upon the projections of the future trend. But no doubt, it
provides a basis to think ahead.

8.3.3 Analysis of Profit & Loss A/c

It is a statement of income and expenditure of an entity for the accounting
period. Every P&L account must indicate the accounting period for which it is
prepared. The items of a P&L account are:
l Gross and Net sales
l Cost of goods sold
l Gross profit
l Operating expenses (including depreciation)
l Operating profit
l Non-operating surplus/deficit (other income-other than operation or loss)
l Profit before interest and tax
l Interest
l Profit before tax
l Tax
l Profit after tax (Net Profit)

Gross and Net Sales:

The total price of goods sold and services rendered by an enterprise,
including excise duty paid on the goods sold, is called Gross sales. Net sales are
gross sales minus excise duties. In other words it is net of what company gets after
paying government duties.
Cost of Goods Sold:
This is the sum of costs incurred for manufacturing the goods sold during
Banking Laws and the accounting period. It consists of direct material cost, direct labour cost, and
(116) Operations - I
factory overheads. It is different from the cost of production, which represents the Financial analysis
cost of goods produced in the accounting year, not the cost of goods sold during the of Banks
same period.
Gross Profit:
This is the difference between net sales and cost of goods sold. Most NOTES
companies show this amount as a separate item. Some companies, however, show
all expenses at one place without showing gross profit a separate item.
Operating Expenses:
These consist of general administrative expenses, selling and distribution
expenses, and depreciation. Some companies include depreciation under cost of
goods sold as a manufacturing overhead rather than under operating expenses.
Operating Profit:
This is the difference between gross profit and operating expenses. As a
measure of profit, it reflects operating performance and is not affected by non-
operating gains/losses, financial leverage and the tax factor.
CHECK YOUR
Non-operating Surplus: This represents gains arising from sources other
PROGRESS
than normal operations of the business.
Its major components are income from investments and gains from disposal Describe Analysis of
of assets. Likewise, non-operating deficit represents losses from activities unrelated
Balance Sheet?
to the normal operations of the firm. For example losses in share investment and
loss in taking some task of consultancy work etc.
Profit before Interest and Taxes:
This is the sum of operating profit and non-operating surplus/deficit. Referred
to also as earnings before interest and taxes (EBIT), this represents a measure of
profit which is not influenced by financial leverage and the tax factor.
These are represented as under:
PBITD = Profit before interest tax and depreciation
PBIT = Profit before interest and tax - it indicates the ability of the firm to
serve interest and taxes.
PBT = Profit before tax
PAT = Profit after tax (also termed as net profit)
Interest:
This is the expenses incurred on account of application of interest for
borrowed funds, such as term loans, debentures, public deposits, and working capital
advances etc.
Profit before tax (PBT):
This is obtained by deducting interest from profits before interest and taxes.
It is also termed as PBIT. It provides an indicator of ability of the firm to pay
interest to banks, other financial institutions and depositors.
Tax:
This represents the income tax payable on the taxable profit of the year.
On this basis of PBT, the tax burden is calculated.
Profit after tax (PAT):
This is the difference between the profit before tax and tax for the year. It
is also termed as net profit of the firm and an indicator of its earning power.

8.3.4 Analysis of Balance Sheet

The balance sheet is the most important financial statement prepared Banking Laws and
Operations - I (117)
Banking Laws and annually. It shows the assets and liabilities of a business concern as at a particular
Operations - I date (For example as on 31st March). The assets indicate what the company owns
and its receivables, Indicating investments outside business and advance paid for
purchases and procurement including deposits against tenders etc. and the liabilities
NOTES indicate what the company owes and its payables.

Assets:
Assets are classified into: (a) Current Assets (b) Fixed Assets (c)
Intangible Assets
Please note that in the vertical form of balance sheet, most of these items
appear as part of application of funds or deployment of funds. The difference of
current assets and current liabilities are added to accommodate current asset surplus
or deficits.
Current Assets: Current assets are those assets which are to be liquidated
into cash in the near future. As per RBI norms this period is 12 months. These
assets are also known as 'circulating assets' or assets created in working capital
zone related from working capital fund plus capital.
On July 19, 1969 the Government of India issued an ordinance and
nationalized 14 major commercial Banks. This was considered as a major revolution
in the Indian banking system.
Composition of Current Assets: Cash and bank balances, marketable
securities, inventories (Raw material, stock in process, finished goods, other stocks),,
bills receivables and debtors (book debts) are usually carried forward Current
Assets. Debts and bills receivable which are outstanding for not more than 12
months are treated as current assets. Advance payment against purchase of materials
or paid as past payment of orders also form a major component of current asset.
Inventories and Receivables are two important components of current
assets. As already indicated while interpreting the financial statements, care should
be taken to bifurcate these assets into two categories as current and noncurrent
assets. A close review of the inventory and receivables would give better results of
the efficiency of the management in managing these two assets, and clearly indicate
the liquidity of the business concern. That is act of good management and control.
Some current assets are litigated and doubtful of recovery and needs to be analysed
carefully.
Fixed Assets: The next important classification of assets is fixed assets.
The fixed assets usually consist of Land and buildings, Plant and Machinery, fixtures
and fittings, Good-will paid while acquiring a company, partial investment in project
. for expansion though not complete, and other equipments like air conditioning, of
premises or workshops etc. These assets are used by the company for carrying on
the business and are not meant for sale in the near future, these are facilities that
help in performing production and / or services. While analyzing the fixed assets,
care should be taken to verify the book value as well as market value (re-saleable
value) and necessary precautions should be taken to verify whether such assets
are charged to any bank or financial institutions. The depreciation and amortization
policies should also be reviewed.
The valuation of the fixed assets varies according to the type of assets.
For example, land should be valued according to ownership pattern like free hold
or lease hold, and the location of the land, etc., As regards valuation of building, the
age of the building, location and other factors need to be given appropriate weightage.
Usually, revaluation of assets is not carried out while preparing the financial analysis.
It is carried out while changing the hand.
Banking Laws and
Intangible Assets: With the changing pattern of integration of global
(118) Operations - I
business environment, a lot of changes are taking place in the way of analysis of Financial analysis
financial statements as well. Importance is being given to the intangible assets, and of Banks
their valuation is an important part of financial analysis.
Generally, the following items are classified as intangible assets; goodwill,
copy right, patents, trade mark, designs, brand value etc. These are also called as NOTES
fictitious assets. These assets do not represent any tangible assets but are of value
for company. Example, goodwill represents the reputation earned by the company.
The loss component in the asset side should be taken as intangible and used in
arriving at tangible asset of the company.
Apart from the above, certain other items which can also be classified as
intangible assets are : preliminary expenses, debit balance in profit and loss account,
which are either deferred revenue expenses or are actual losses to be written off
over a period of time. The receivables that are involved in legal-trap should be put
as doubtful of recovery and carefully examined.
Liabilities: The liabilities mainly represent sources of funds and can be
broadly classified into: (i) Net Worth -
Owned funds and share capital and free reserves (ii) Current liabilities
and (iii) Long term liabilities
Current liabilities: Those items which are repayable within one year
are treated as current liabilities. Apart from the above items, provision for taxes,
interest on term loans and debentures and other charges, unpaid expenses, etc. are
classified as other current liabilities. This indicates sundry creditors (goods), sundry
creditors (expenses), advance received against order to be executed deposits etc.
Borrowings from banks: Business units avail bank finance in the form
of term loan for acquiring fixed assets and working capital including bill limit to
create current assets and export credit etc. An analyst should be interested to
know the details of such bank borrowings like amount under different categories,
security charged to the banks in the form of hypothecation or pledge of inventories
or/and receivables etc.
Sundry or Trade Creditors: The review of trade creditors is crucial in
determining the company's liquidity management. The review should be in detail
relating to the nature of bills, the credit terms and other conditions. If the bills are
drawn by other than trade creditors, then cautious and careful review is needed.
Term Liabilities: The term liabilities are long term in nature, but the
installments of term loans which are repayable or the maturity of debentures and
other term liabilities which are due for payment within a period of one year, need to
be classified as short term and treated like other current liabilities. These liabilities
are term loan from banks and other financial institutions like IDBI, NABARD,
Exim-Bank etc.
Term loans are classified into short term, medium term and long term.
Medium term and long term are usually availed by companies for creating
manufacturing facilities i.e. land and building, plant and machinery, preoperative
expenses, take over, amalgamation ,The period of loan is mostly more than 5 years
and less than 10 years. In case of government projects having SCB (Social Cost
Benifits) this may extend up to 30 years (world bank loan etc.)
While analyzing these, care should be exercised to verify and satisfy the
various terms and conditions of the loans and term finance availed by the company.
The details such as the rate of interest, the repayment period, and the security
offered etc., needs to be carefully reviewed. Term loans have terms of repayment
and need to be repaid as per schedule of repayment, the cash credit are short term
loan to be paid on demand and is for current asset creation.
Banking Laws and
Net Worth: The composition of 'net worth' is paid-up share capital, the Operations - I (119)
Banking Laws and retained profits (plough back profit) held in the form of reserves and surpluses and
Operations - I the credit balance in the profit and loss account.
One of the important aspects of "net worth" is that the company's long
term solvency depends on the strong capital base. The financial analyst should
NOTES review this to find out whether the long term needs of the business concern are
financed by the owned funds or borrowed funds. The net worth shows the own
financial standing of the business.
Take the case of Kingfisher where entire equity was eroded. On other
hand there are debt free companies like Coca Cola etc. and that their net worth is
nearly equal to their total assets. That means the assets are fully owned by them
and liability-free.
Contingent Liabilities or Off Balance Sheet Items: Contingent
liabilities are those liabilities which do not exist as on the date of balance sheet,
however they may arise in future. Unlike other items, which are classified as
balance sheet items, the contingent liabilities are classified as off balance sheet
items. The balance sheet items are part of the balance sheet as historical items,
whereas the contingent liabilities are future items. In case these items
become payable, it would distort the liquidity position of the company, hence
a careful review as to the terms and conditions of such contingent liabilities, possible
repayment amount and time etc., need to be given importance.
Other important features: The balance sheet and the profit and loss
account give the financial position of a company in numerical numbers. Apart from
these, the auditors' report, explanatory schedules and notes on accounts, if applicable,
provide useful information. Today there is a chapter on management audit that
includes the sound working or difficulties of management and help in analysing the
fact.
Funds flow and cash flow statements also provide useful information which
show mathematical analysis of changes in the structure of two consecutive balance
sheets. The financial statements should be prepared as per the legal framework
and the Accounting standards as applicable from time to time.
In case of banking companies, the formats of both balance sheet and P&L
account are prescribed by the Banking Regulation Act. In case of other companies,
they have to follow the Companies Act, 2013, as amended from time to time.
The Ministry of Corporate Affairs (MCA) has issued revised Schedule VI
which lays down a new format for preparation and presentation of financial
statements by Indian companies for financial years commencing on or after 1 April
2018.
The revised Schedule VI has introduced some significant conceptual
changes such as current/non-current distinction, primacy to the requirements of
the accounting standards, etc. While the revised Schedule does not adopt the
international standard on disclosures in financial statements fully, it brings corporate
disclosures closer to international practices.

Some of the significant aspects of the revised Schedule are:

l Format of cash flow statement not prescribed - hence companies which are
required to present this statement (i.e., other than small and medium sized
companies) to continue to prepare it as per AS 3, Cash Flow Statements
l Only vertical form of balance sheet is allowed - with significant changes vis-
a-vis the structure of pre-revised Schedule VI
l Shareholders' funds to be shown after deduction of debit balance of statement
Banking Laws and of profit and loss. 'Reserves and surplus' and 'shareholders' funds' (i.e.,
(120) Operations - I
 aggregate of Share Capital and Reserves and Surplus) could thus be negative Financial analysis
figures. of Banks
l Miscellaneous expenditure can no longer be shown as a separate broad
heading under 'Assets'. It would be required to be reclassified depending on
the nature of each such item. NOTES
l All assets and liabilities to be classified into current and non-current. This
provides useful information by distinguishing assets/liabilities continuously
circulating as working capital or expected to be settled/ realized within 12
months from the balance sheet date from those used in long-term operations.
Current/noncurrent distinction will have major impact on classification of
accounting information and account heads. Hence, changes would be required
in accounting systems and procedures.
l Detailed disclosures required regarding defaults on borrowings.
l All liabilities to be classified into current and non-current on the basis of the
same criteria of distinction as in the case of assets.
CHECK YOUR
l Non-current liabilities include long-term borrowings, long-term maturities of PROGRESS
finance lease obligations, long term trade payables and long-term provisions.
Current liabilities include current maturities of long-term debt and of finance
Describe Analysis of
lease obligations, short-term borrowings, and all borrowings repayable on
Cash Flow and Fund
demand, unpaid matured deposits/debentures, and short-term provisions.
Flow Statements?
l Intangible fixed assets to be disclosed separately.
l 'Investments' no longer a broad head - to be included under non-current and
current assets categories;
l Long-term loans and advances given - not to be clubbed with current assets.
l Cash and cash equivalents to be disclosed separately.
l 'Investments' no longer a broad head - to be included under non-current and
current assets categories;
l Long-term loans and advances given not to be clubbed with current assets.
l Cash and cash equivalents to be disclosed separately.
l Statement of profit and loss
l Format of statement of profit and loss prescribed - classification of expenses
by nature.

Various computations relating to profits (losses) to be shown:

l Profit (loss) before exceptional and extraordinary items and tax
l Profit (loss) before extraordinary items and tax
l Profit (loss) before tax
l Profit (loss) from continuing operations
l Profit (loss) from discontinuing operations
l Profit (loss) for the period

8.4 Analysis of Cash Flow and Fund Flow Statements

Each item in the balance sheet represents either source of funds or use of
funds. All items on the liabilities side represent the funds provided to the enterprise
and all items on the assets side (except cash) represent use of these funds. Also
the total sources of funds less uses of funds equals cash balance and used to check
the accuracy of the funds flow. Banking Laws and
Operations - I (121)
Banking Laws and When we compare two balance sheets of different dates, change in each
Operations - I item (or introduction of a new item) in the balance sheet of later date, as compared
to that item in the balance sheet of earlier date, will represent either addition of
funds or additional use of funds in the intervening period. Any increase in any item
NOTES on the liabilities side means additional funds available. It should be noted that
additional funds are injected during the period and is worked out as increase of
fund. It should also be noted that additional funds are also available if there is
decrease in any item on the assets side. Similarly, any increase in any item on the
assets side or decrease in any item on the liabilities side means additional use of
funds. A statement of these additional sources and uses of funds is called Funds
flow statement for the intervening period. A tabular format for easy understanding
is given below:-
- Increase in liabilities o Source of fund
- Decrease in liabilities o Uses of fund
- Increase in assets o Uses of funds
- Decrease in assets o Sources of funds
CHECK YOUR
If we have to prepare the cash flow statement, we start with the cash in
PROGRESS
the first balance sheet as opening balance, add all the additional sources, excluding
cash (cash is also a source of funds if it is at a reduced level in the subsequent
Describe Financial
balance sheet), and deduct all additional uses (excluding cash), thus arriving at the
Analysis Techniques? closing balance, which will be equal to the cash shown in the second balance
sheet. In practice, the statement is prepared perceiving cash as a use or source of
funds. For analysts, banks and auditor funds flow helps in pin pointing the diversion
of funds. Mainly when the short term sources are used for long term uses, it is
dangerous as the fund for working capital has been diversified for acquiring fixed
assets and it affects the working cycle.

8.5 Financial Analysis Techniques

8.5.1 Fund Flow Analysis
Funds flow indicates the flow of working capital between two balance
sheet dates. It involves information relating to the various changes in working
capital during the period involved. Every change in working capital is associated
with a flow which could either be an inflow (sources of fund) or an outflow (uses
of fund). Under funds flow analysis these inflow and outflow of funds are analysed
to explain the change in working capital between the two points of time. The total
sources of funds are categorized as 'Long term' and 'Short term'. Similarly, the
total uses are also categorized as 'Long term' and 'Short term'. If the short term
sources are more than the short uses, it indicates diversion of working capital
funds and needs to be probed further. Sometimes, it may be a desirable thing e.g.,
in case of companies with very high current ratio, it may be desirable to use the idle
funds for creating additional capacity. The guiding principle is that this diversion
should not affect the liquidity position of the company to unacceptable level. In
other words the current ratio as directed by banks should be maintained.

8.5.2 Ratio Analysis

This is the most commonly used tool for analysis of financial statements.
A ratio is comparison of two figures and can illustratively be expressed as:
Current Ratio 8.33
Banking Laws and Debt Equity Ratio 1:2
(122) Operations - I
 Profitability Ratio 28.4% Financial analysis
Both the figures, used in calculation of a ratio, can be from either P& L of Banks
account, or balance sheet or one can be from P& L account and the other from
balance sheet. Ratios help in comparison of the financial performance and financial
position of an entity with other entities, as also for comparison with its own status NOTES
over the years. While different users of financial statements are interested in
different ratios, some of the important ratios are:
Profitability Ratios:
Operating profit margin (OPM) and Net profit margin (NPM) are calculated
by dividing the figures of operating profit (EBIT which means earnings before
interest and tax) and net profit respectively by the net sales. OPM is an indicator
of the operating efficiency of the enterprise while NPM is an indication of ability to
withstand the adverse business conditions.
Liquidity Ratios:
These are Current ratio (CR) and Quick ratio or acid test ratio. While CR
is a ratio of total current assets to total current liabilities, quick ratio is calculated by
dividing current assets (excluding inventory) by total current liabilities.
These ratios indicate the capacity of an enterprise to meet its short term
obligations. It is quick ratio because out of total current asset the inventory is taken
out and the balance is mostly Sundry Dr. or advances as paid and are nearer
(quick) to be converted in to cash.
Capital Structure Ratios:
Debt Equity Ratio (DER) is a ratio of total outside long term liability to the
Net worth of an enterprise. High debt equity ratios are an indication of high
borrowings in relation to the owned funds but also affects the viability of the operation
of the enterprise, as higher borrowings mean higher costs and lower operating
margins. In case of those enterprises, which are not capital intensive (i.e. the
requirement of fixed assets is low), this ratio may not indicate the correct picture
as working capital borrowings, which are not indicated by DER, may be
disproportionate to the capital. To get a better result, the ratio of Total Outside
Liabilities (TOL) to Tangible Net Worth (TNW) can be used.
For bank and auditors the bad ratio indicates higher risks for the company
and may be a guide line to plough back more profit within the business.
Coverage Ratios:
Interest Coverage Ratio (ICR) and Debt Service Coverage Ratio (DSCR)
are the important ratios under this category. ICR is calculated by dividing EBIT
(earnings before interest and tax) by total interest on long term borrowings.
DSCR is ratio of total cash flows before interest (net profit + depreciation
+ interest on long term borrowings) to total repayment obligation (installment +
interest on long term borrowings).
Turnover Ratios:
Inventory Turnover Ratio:
This is one of the important ratios to measure the skills of the management
of the firm. This is an indicator of how fast or slow is the movement of inventory.
It is calculated by dividing cost of goods sold by average inventory. A higher ratio
indicates faster movement of inventory. This is also used for calculating average
inventory holding period. Also it indicates a faster working capital borrowed and
helps in lower interest liabilities. Today use of just in time and lean production
system helps to a greater extent in reducing inventory level.
Debtors' Turnover Ratio: This is another important ratio to measure the
Banking Laws and
efficiency of the receivables management of the firm. It is an indicator of how fast Operations - I (123)
Banking Laws and or slow the debtors are realized. It is calculated by dividing the net credit sales of
Operations - I a company by average debtors outstanding during the year. A higher ratio indicates
faster collection of debts. This is also used for calculating average collection period.
For this the formula is: Total Credit Sales ÷ Average Sundry Dr, in case it
NOTES comes 4 : 1, the relation will be (12 months ÷ 4) = 3 months

8.5.3 Trend Analysis

Under trend analysis, methodology can be used:
(a) The items, for which trend is required to be seen, are arranged in horizontal
form and percentage increase (decrease) from the previous year's figure
is indicated below it. Generally, this is used to analysis the trends of
sales, operating profit, PBT, PAT etc. from P& L account. Similarly, the
balance sheets, arranged in horizontal order give the trends of increase
or decrease of various items.
(b) Common size statements are prepared to express the relationship of
various items to one item in percentage terms. For example, consumption
of raw materials is expressed as a percentage of sales for different
years and comparison of these figures gives indication of trend of
operating efficiency.
The use of common size statements can make comparisons of business
enterprises of different sizes much more meaningful since the numbers are brought
to common base, i.e. per cent. Such statement allows an analyst to compare the
operating and financing characteristics of two companies of different sizes in the
same industry. To quickly understand a good or negative trend the chart below
should be of good help:-

Sl. No. Trend Positive Negative

1 Increase in PBT Yes -
2 Decrease in PBT - Yes
3 Increase in PAT Yes -
4 Decrease in PAT - Yes
5 PBIT Increases Yes -
6 PBIT Decreases - Yes
7 Net Worth Increases Yes -
8 Net Worth Decreases - Yes

8.5.4 Du Pont Analysis

The Du Pont Company of US introduced a system of financial analysis
considered as one of the important tool for financial analysis. The usefulness of the
Du Pont model is that it presents a picture of the overall performance of a company
to enable the management to identify the factors relating to the company's
profitability.
The Du Pont identifies that the earning power of a firm is represented by
(Return on Capital Employed) ROCE. ROCE shows the combined effect of the
profit margin and the capital turnover. A change in any of these ratios would change
the company's earning power. These two ratios are affected by many factors. Any
change in these factors would bring a change in these two ratios.
The two components of this ratio: profit margin and investment turnover
Banking Laws and ratio individually cannot give the overall view because the profit margin ratio ignores
(124) Operations - I
the profitability of investments and the investment turnover ratio ignores the Financial analysis
profitability on sales. of Banks

ROCE = Turnover x Profit Margin

NOTES
Turn over = Sales/ Capital Employed
Capital Employed = Working Capital + Fixed Assets
Working Capital = Stock + Bills Receivable + Debtors + Cash
Profit Margin: Net Profit/ Sales
Net Profit = Sales - (Manufacturing costs + Selling costs + Administrative costs)

8.6 Special issues in financial analysis - Banking

Industry:
The primary business of the banks is to deposit funds and pay interest that
is expenditure for them and the source of income in lending these funds to business,
agriculture and industry etc. and charge interest to meet the expenses and earn
reasonable profit for growth and survival.
Banks are financial intermediaries playing a crucial role of connecting the
depositors (who save money) and the borrowers (who need money). Banks borrow
money in the form of acceptance of deposits both from retail and wholesale
customers (depositors) as well as banks and financial institutions. The funds are
deployed as assets. Bank assets can be broadly classified into (i) Loan assets (ii)
Investments and (iii) Other assets (fixed assets)
In both capacity as lending banker and investing banker, a banker needs
to be careful. He needs to carry out as due diligence exercise for various
reasons:
l Safety and security is the concern of a lending and investing banker, since he
also acts as trustee for the depositor's money.
l While lending as well as investing, banks are exposed to many risks.
l Banks needs to balance their assets and liabilities, and also ensure proper
liquidity management.
l Banks should carefully handle their assets portfolio to ensure that their NPA
levels remain at minimum possible levels.
In view of the above, a banker's financial analysis would be different from
other category of persons and entities that use the financial statements for various
purposes and reasons.

8.7 Financial analysis by bank as lender

The worldwide major definition of an entrepreneur is "one who takes
Calculated Risk". Since Risk term is there all the 100% borrowings may not show
a success. In the beginning itself the project or person should be judged by using
financial analysis to understand past trend and future projections and arrive at a
safer decision (not higher in risk). While considering a loan proposal, apart from
the borrower's integrity and KYC aspects, the banks are interested in knowing the
financial details of the prospective borrower. The extent of these details depend
upon the type of loan, type of borrower, purpose of the loan etc. In case of security
based lending like loans against fixed deposits, etc, these financial details may be
Banking Laws and
few or may not be required at all. However, in other cases of both fund based as Operations - I (125)
Banking Laws and well as non fund based limits, banks need to ensure collection of all relevant financial
Operations - I data, and other relevant information, to make a proper decision. Some of the
important areas are:

NOTES (1) Net Worth of the borrower:

For an individual, the excess of his assets over his liabilities is his net
worth. The same thing applies to any business entity as well but, to consider various
types of loans and advances, banks should be careful to evaluate the net worth.
This helps in understanding that the borrower is of good worth to raise funds to
meet the margin component of loan and DER (Debt Equity Ratio) should be adequate
(more than 2:1).
(2) Viability:
Banks should assess the viability of the business unit, most its operational
capacity and its ability to increase it's production with the proposed bank loans.
This is one of the important consideration for a bank in credit assessment (working
capital finance and term finance). A scrutiny of the financial records of the existing
activities help bank in assessing whether the proposed bank loan will result in a
significant increase in operations. The viability covers two aspects and that being
technical feasibility and economic viability of the projects.
(3) Repayment Capacity:
Depending upon the type of borrower, his loan repayment capacity is
determined. In case of an individual, the banks collects information like his income
(salary, interest, dividend, etc.) and also his expenditure, including repayments of
existing borrowings, if any, to assess the surplus available for repayment of installment
and interest on bank's loan. However, in case of a business concern, banks obtain
most of the required information from its financial statements and for other
information banks collect information through their due diligence process.
(4) Assessment of Performance and Financial Position:
An analysis of the financial statements reveals the trend of growth of
business and its profitability. The review of the financial statements reveal the
composition of assets and liabilities of the company. By comparing these to the
industry trend, risk factors are identified and and opinion about the management
and efficiency of the enterprise is formed. This also indicates the Risk factors in
various financial management areas by the management of the company.
(5) Financial Health Indicators:
Financial statement analysis is an important tool in identifying direction of
business of the company. It also assists the bank in determining the status of the
financial health. The financial analysis helps the banker to detect any deterioration
of its financial health and enable the bank to take preventive/ corrective measures
to avoid/ minimize losses. It also provides room to the bank infusing additional loan
for expansion or increase in level of operation by enhancing the loan limits.
(6) Assessment of Credit Requirements:
Despite all best efforts, one of the difficulties faced by the banks is to
accurately assess the financial need of the borrower. Over-financing and under-
financing both are risky for the borrower as well as for the bank. Financial statement
analysis is used by banks to assess the credit requirement to overcome this issue.
Banks are also concerned with repayment of loan interest within a reasonable
time. Analysis of the financial statements of the borrower helps to assess the
repayment schedule and also to assess credit risk and decide the terms and conditions
of loan. The analysis also indicates the diversion of the fund outside the company
Banking Laws and or within the company, not in good taste
(126) Operations - I
(7) Cross Verification: Financial analysis
The statements of stocks and book debts, as on the date of the balance of Banks
sheet, submitted by the borrower, for calculation of drawing power in the cash
credit account, are cross checked with the figures given in the balance sheet. In
case of doubt, while assessing working capital requirements, physical stock statement NOTES
of inventories held should be critically examined. Stocking of stocks can be
categorized into three that are Fast moving stocks, Slow moving stocks and Non-
moving stocks, termed as (FSN). Also, out of Sundry Dr the doubtful Sundry Dr.
needs to be examined. This helps in proper purification of working capital
requirements and saves the future prospect of survival and growth.

8.8 Banker as Investor

As per bank's investment policy and guidelines of the regulator, banks
invest in securities under SLR and Non SLR investment categories.
These investments are made by banks for the following reasons:
CHECK YOUR
(1) To comply with SLR requirements PROGRESS
(2) To optimally deploy surplus funds
(3) To manage the gap between assets and liabilities (mismatch) Describe Banker as
(4) To diversify risks Investor?

While investing funds in Non-SLR securities, the following need to be

taken into account:
1. They should adhere to exposure limits and counter-party limits.
2. The financial statements of banks and corporate clients, where the funds
would be invested, need to be properly analyzed.
3. Like a lending banker, the investing banker also needs to verify all the
important parameters to cover various risks.
4. If the investments are in market related instruments, banks also need to
do a proper analysis of the market risks and their impact
5. Banks should ensure that all such investments are properly valued by
practicing the mark-to-market concept.
6. Apart from trend ratio and other analysis, banks should also carry out
PESTEL analysis (Political, Economic, Social, Technological,
Environmental and Legal) and impact of the PESTEL factors on their
investments.
7. To protect the interests of the bank, while investing, careful assessment
of the company's performance and stock markets, also needs to be
carried out.
8.9 Key concepts
The Balance sheet shows the financial position of the business as at the
end of a particular period (month, quarter or year).
P & L account is a statement of income and expenditure of an entity for
the accounting period.
Du Pont model highlights that the earning power of a firm is represented
by Return on Capital Employed (ROCE).

Banking Laws and

Operations - I (127)
Banking Laws and
Operations - I 8.10 Summary
l The main source of Financial analysis is the financial statements viz., the
balance sheet, profit and loss account, cash flow and funds flow statements.
NOTES
l The balance sheet depicts the position of its assets and liabilities as on a
particular date, while P&L account is prepared for an accounting period and
states the position of income, expenses and the profit/ loss.
l Different methods of analysis are used on the basis of comparison of two
successive balance sheets.
l We can calculate the flow of funds in the intervening period.
l The credit and investment decisions are applicable for future needs of an
enterprise, for which usually projected financial statements are also prepared
and analyzed.
l These are based on actual statements for the past period and anticipated
performance in the future.
l Analysis of financial statements helps banks in knowing the financial health,
performance and viability of an enterprise, and in assessing its credit
requirements.
l Some of the important methods used in analysis are trend and ratio analysis.
l The trend analysis shows how the business of an enterprise is growing while
the ratio analysis depicts the most critical financial parameters at a glance.
Thus, the key ratios like OPM, debt/equity ratio, current ratio, DSCR, debtors'
turnover ratio assist an investor and a lender to get a reasonable understanding
about the financial health and the performance of an enterprise. However,
for a final decision, a more detailed analysis is necessary.
l While the format for balance sheet and P&L account are prescribed, for
meaningful analysis, rearrangement of these statements into various groups
can be done according to the requirement of the analyst.
l Du Pont model highlights that the earning power of a firm is represented by
Return on Capital Employed (ROCE). ROCE shows the combined effect of
the profit margin and the capital turn over. Any change in any of the factors
affects the company's earning power.
l Banks as lender and investor, carryout financial analysis. While analyzing
the company's performance based on the financial statements, banks should
also be careful to give due attention to other factors apart from the financial
statements.

8.11 Exercise
Fill in the blanks
1. Financial statements are drawn as per the accounting standards and as per
the regulatory and legal frame work. Thus, these statements provide a
________ presentation which makes the analysis comparable.
(homogeneous, heterogeneous, simple)
2. The sum of costs incurred for manufacturing the goods sold during the
accounting period is called as ______________.
(cost of goods sold, cost of sales, cost of production)
3. _____________ provides an indicator of ability of the firm to pay interest
Banking Laws and to banks, other financial institutions and depositors.
(128) Operations - I (PBIT, PAT, PBT)
4. Current assets are those assets which are to be liquidated into cash in the Financial analysis
near future. As per RBI norms this period is __________. of Banks
(12 months, 6 months, 10 months)
5. One of the important aspects of "_________" is that the company's long
term solvency depends on the strong capital base. NOTES
(net worth, net asset, net profit)
6. ________________ is a ratio of total outside long term liability to the Net
worth of an enterprise.
(Debtors' Turnover Ratio, Debt Equity Ratio, Debtors' liability Ratio )
7. A higher inventory turnover ratio indicates _________ movement of inventory.
(slower, faster, no)
8. _________ is important ratio to measure the efficiency of the receivables
management of the firm.
(Debtors' Turnover Ratio, Debtors' Equity Ratio, Debtors' liability Ratio )
9. In ________, Common size statements are prepared to express the
relationship of various items to one item in percentage terms.
(ratio analysis, trend analysis, equity analysis)
10. The financial statements of a company for financial analysis are used by
bankers &___________
(Investors, Credit Rating Agencies, Government)
11. DuPont analysis include the following items, except ____________
(ROCE, Fixed Assets, Goodwill)

[ANS: 1)Homogeneous 2)cost of goods sold 3)PBIT 4)12 months 5)Net

Worth 6)Debt Equity ratio 7)faster 8)Debtors' Turnover Ratio 9)Trend
Analysis 10)Credit Rating Agencies 11)Goodwill]

8.12 Further Readings & References

1. M.L.Tannan, revised by : Banking Law and Practice, Wadhwa & Company,
Nagpur C.R. Datta & S.K. Kataria
2. A.B. Srivastava and : Seth's Banking Law, Law Publisher's India (P) Limited
K. Elumalai
3. R.K. Gupta : BANKING Law and Practice in 3 Vols. Modern Law Publications.
4. Prof. Clifford Gomez : Banking and Finance - Theory, Law and Practice, PHI
Learning Private Limited
5. J.M. Holden : The Law and Practice of Banking, Universal Law Publishing.

Banking Laws and

Operations - I (129)
Banking Laws and
Operations - I UNIT 9
RISK MANAGEMENT IN BANKS
NOTES Structure
9.0 Introduction
9.1 Objectives
9.2 Risks
9.3 Features of Risk Management
9.4 Risk Management Structure
9.5 Risk Management under BASEL I
9.6 Risk Management under BASEL II
9.7 Credit Risk Management
9.8 Liquidity and Market Risk Management
9.9 Market Risk
9.10 Equity Price Risk
9.11 Commodity Price Risk
9.12 Cross Border Risk
9.13 Country Risk:
9.14 Country Risk Management System (CRMS)
9.15 Operational Risk
9.16 Legal Risk
9.17 Risk Management under BASEL III
9.18 Reporting of Banking Risk
9.19 Key concepts
9.20 Summary
9.21 Exercise
9.22 Further Readings & References

9.0 Introduction
With the fast changing global business environment banks as part of the
financial sector and as an important financial intermediary, handles different types
of financial transactions.
In view of the presence of the banks across globe, and their interconnectivity
through branch net work and correspondent banking relations, banks are exposed
to various types of risks. On account of their operations at different markets, banks
are facing uncertainties in their operations, which are not only spread across different
financial centers, but also more are less operative on 24 x 7 basis, and on different
time zones. As such, the impact of various risks either directly or indirectly affects
the banks' operations. In this unitthe different types of risks and the systems and
procedures to manage the risks are covered.

9.1 Objectives
After reading this unit, you should be able to:
Banking Laws and
- Understand the various types of risks associated with banking companies
(130) Operations - I
 - Appreciate the role of the Regulators in managing such risks Risk Management
- Know the importance of risk management in banks and the guidelines in Banks
of the Basel Committee
- Integrate the effectiveness of different types of risks and the reasons
thereof and various methods to manage risks NOTES

9.2 Risks
A risk arises on account of an uncertain event, which might result in a loss
or gain to the parties associated with such risk. Even though the risk is an independent
event, invariably risks are interlinked in the sense; one risk may lead to other risks
as well.
Risks can be classified into various types. Few examples of risks are shown
in the following diagram:

Credit Liquidity Interest Rate CHECK YOUR

PROGRESS

Describe Risks?
Legal Price Foriegn
Exchange

Regulatory Operational Cross

Border

As per the Basel norms, these risks are broadly classified into three:

Credit
+
Market Risk
+
Operational

The first diagram indicates various risks and the second diagram shows
three important classifications of the risks.
To illustrate how these risks are interlinked, let us take examples of two
market situations.
(1) Bank A lends to B Rs.10,00,000.00 for a period of six months. On the
due date (maturity of the loan) borrower B needs to repay to Bank A Rs. 10,00,000.00
+ applicable interest. Assuming on the due date if B fails to repay the amount, then
it becomes a credit risk for bank A, on account of default in payment by the borrower.
On account of the non receipt of the funds, Bank A would face another risk called
liquidity risk. Not only that, it would lead to a situation of asset liability mismatch
(gap risk) for bank A. In view of the shortage of funds, and also to manage the
mismatch in its asset liability, bank A should arrange for funds from (a) accepting
new deposits and/or approach the market to borrow at the markets interest rate.
Banking Laws and
Hence bank A would be facing the market risk (and needs to pay the market Operations - I (131)
Banking Laws and interest rate). In the ordinary course, these transactions would not have arisen, if
Operations - I the borrower B had repaid his loan on the original due date.
Further, our assumptions are that after few days, if borrower B repays the
loan amount and interest thereof, once again the bank A would face asset liability
NOTES mismatch on account of funds received. Such funds need to be deployed in the
market subject to market interest rate. Assuming on the date of deployment if the
market rates come down, the bank A would face a loss. A recap of this illustration
would show case how; one risk is extended to series of risks. Credit risk - liquidity
risk - mismatch (gap) risk - market risk (interest rate)
(2) Bank X entered into a spot forex deal with Bank Y. Bank X agreed to
sell US$ 1 million to Bank Y at a particular exchange rate. On the date of delivery
Bank Y settled the equivalent rupee funds to Bank X.
However, Bank X could not deliver the US$ 1 million. So Bank Y is facing
a credit risk, also called settlement risk. This would lead to further risks for Bank
Y. There would be shortage of funds in the Nostro account of Bank Y. Bank Y
needs to fund the account and should (a) either arrange for a fresh deal and/or (b)
CHECK YOUR borrow in US markets at the market's interest rate. The non receipt of US funds
PROGRESS has created not only credit risk, but also liquidity as well as mismatch risk in the
assets and liabilities of the bank Y. Further on account of approaching the forex
Describe Features of markets as well as US market, to enter into a new forex deal and to borrow funds
Risk Management? in the US market, bank Y would also face market risks (viz., Exchange Rate risk
and Interest rate risk respectively). Basel Norms categorized these risks broadly
into three viz, (1) Credit Risk (2) Market Risk and (3) Operational Risk
We have seen examples of Credit Risk and Market Risk and how these
are interlinked.
Let us take another example i.e., Operational Risk: Apart from credit and
market risks, other risks can be recognized as part of operational risk. Operational
risk mainly arises out of non adherence to the regulatory directives, guidelines, non
compliance of legal frame work, on account of human and system errors, natural
disasters, and also on account of frauds, misappropriation of funds, weak internal
control systems etc. Any risk which arises out of one or more factors mentioned
above can be recognized as operational risk. Any of the operational risk would
create a credit risk for the counter party, and as already explained above, there
would be chain effect, like operational risk credit risk-. liquidity risk - mismatch
(gap) risk - market risk (interest rate).
In view of the above, banks should be very careful in their risk management.

9.3 Features of Risk Management

1. Risk management policies should be approved by the board. It should
cover all the required guidelines and directives of the regulators and
applicable legal frame work
2. There should be a good support from the Information Technology wing
for creating an integrated system whereby an effective and efficient
MIS would be an integral part of the risk management
3. There should be clear demarcation of functions and authority levels to
ensure better internal control systems (ex: front office, mid office and
back office of an integrated treasury)
4. An effective communication system coupled with the training programs
5. One of the risk mitigation measures is to setup appropriate limits for
Banking Laws and various aspects like counter party limit, country limit, currency limit,
(132) Operations - I
 over night and intraday limits, stop loss limit, individual and group exposure Risk Management
limits etc. in Banks
6. Inbuilt checking and balancing systems, such as input and output controls,
access control to the computer systems, and sensitive areas of the banks
7. Apart from review by the ALCO members, a periodical review and NOTES
evaluation system should be in place. Risk Management is a methodology
that helps managers make best use of their available resources. The
process consists of important steps like:
- Identify
- Analyze
- Evaluate
- Monitor

Identification of risks:
Identify the types of risks that are associated with the banking business
and operations. Define the types of risk, with special reference to the goals and
objectives of the organization. Based on the past experience and future forecasts,
risks can be identified and classified in to different levels like High, Medium and
Low levels The objective of risk identification is the early and continuous
identification of events that, if they occur, will have negative impacts on the project's
ability to achieve performance or capability outcome goals. They may come from
within the project or from external sources

Analyzing the risks:

Risks arise out of many factors like, PESTEL factors, Micro and
Macroeconomic policies, ineffective internal control systems, speculation etc., Risks
can be identified by means of using various analysis like financial, technical, trend
and sensitivity analysis based on probability, trend , etc.,
Risk analysis can be defined in many different ways, and much of the
definition depends on how risk analysis relates to other concepts. Risk analysis can
be "broadly defined to include risk assessment, risk characterization, risk
communication, risk management, and policy relating to risk, in the context of risks
of concern to individuals, to public- and private-sector organizations, and to society
at a local, regional, national, or global level

Evaluating the risks:

The risk may be evaluated by following the Regulators guidelines and
directives and also based on past experiences as well. At the time of evaluation,
proper weightages needs to be assigned for different types of risks as per banks'
risk management policies, such as, risk category, cost associated in managing such
risks and also the impact of such risks. Once risk has been identified to the business,
it is needed to assess the possible impact of those risks. It is essential to separate
minor risks that may be acceptable from major risks that must be managed
immediately.

Monitor and review:

Monitoring and review process is an important segment in risk management.
An effective monitoring system would assist bank management to identify or forecast
risks to enable it to strengthen risk management with more controls to manage the
risks which might arise from their business models and their exposure to various Banking Laws and
Operations - I (133)
Banking Laws and markets, across borders. In identifying, prioritizing and treating risks, organizations
Operations - I make assumptions and decisions based on situations that are subject to change,
(e.g., the business environment, trading patterns or government policies).

NOTES Mitigation of risks:

One of the main objectives of the Risk Management is to ensure that risks
are either avoided or minimized. While it is agreed that not all risks can be avoided,
good risk management practices should create an effective system of mitigation of
risks.
Risk mitigation planning is the process of developing options and actions to
enhance opportunities and reduce threats to project objectives . Risk mitigation
implementation is the process of executing risk mitigation actions.
Risk mitigation progress monitoring includes tracking identified risks,
identifying new risks, and evaluating risk process effectiveness throughout the
project

CHECK YOUR
PROGRESS 9.4 Risk Management Structure
Describe Risk Banking companies should create an effective risk management structure
Management to handle the risks associated with the bank's business models and operations. The
Structure? risk management structure should cover the Credit, Market, Operational and other
risks. The structure should be ably supported by the technology in identification
and monitoring process of risks.
The Risk Management Committee should be formed at the Board level
with the overall responsibility to monitor and manage the overall risks of the bank.
Asset-Liability Management Committee (ALCO) is a strategic decision
making body, formulating and overseeing the function of asset liability management
(ALM) of a bank.
ALCO is headed by the Managing Director or the Chief Executive Officer.
The functions of these risk management committees are to identify, assess,
evaluate, monitor and measure the risk profile of the bank. The Risk Management
Committee also develops the policies and procedures, reviews the pricing models,
and also identifies new risks. The Risk Management Committee is assisted by
other individual risk management sub-committees.

9.5 Risk Management under Basel I

The Basel Committee on Banking Supervision (BCBS) is a committee
which was set up by the Central Bank Governors of a group of ten countries, to
address international issues relating to the banking supervision. The Basel Committee
on Banking Supervision in 1988 came out with a Capital Accord for banks, covering
the areas of risks in respect of banks' assets and liabilities in the balance sheet and
off balance sheet exposures. Under the Basel I Accord, only the credit risk factor
was considered and the minimum requirement of capital funds was fixed at 8 per
cent of the total risk weighted assets. In India, banks are required to maintain a
minimum of 9 percent (Capital to Risk Weighted Asset Ratio - CRAR) on an
ongoing basis.
Pitfalls of Basel I
Basel I Capital Accord has been criticized on several grounds. The main
Banking Laws and criticisms include the following:
(134) Operations - I
 - Limited differentiation of credit risk Risk Management
There are four broad risk weightings (0%, 20%, 50% and 100%), based in Banks
on an 8% minimum capital ratio.
- Static measure of default risk
NOTES
The assumption that a minimum 8% capital ratio is sufficient to protect
banks from failure does not take into account the changing nature of
default risk.
- No recognition of term-structure of credit risk
The capital charges are set at the same level regardless of the maturity
of a credit exposure.
- Simplified calculation of potential future counterparty risk
The current capital requirements ignore the different level of risks
associated with different currencies and macroeconomic risk. In other
words, it assumes a common market to all actors, which is not true in
reality.
- Lack of recognition of portfolio diversification effects
In reality, the sum of individual risk exposures is not the same as the risk
reduction through portfolio diversification. Therefore, summing all risks might provide
incorrect judgment of risk. A remedy would be to create an internal credit risk
model - for example, one similar to the model as developed by the bank to calculate
market risk. This remark is also valid for all other weaknesses.
These criticisms have led to the creation of a new Basel Capital Accord,
known as Basel II, which added operational risk and also defined new calculations
of credit risk. Operational risk is the risk of loss arising from human error or
management failure. Basel II Capital Accord was implemented in 2007

9.6 Risk Management under Basel II

The Second Accord brought in significant changes in risk management in
banks. The Basel II accord introduced a new approach based on the three pillars:
Pillar I: Minimum Capital Requirements:
The minimum capital requirement should be calculated based on three
risks viz., (a) Credit Risk - (i) Standardized Approach (ii) Internal Ratings Based
Approach (b) Operational Risk and (c) Market Risk
Pillar II: Supervisory Review Process:
This pillar addresses the issues like the key aspects of supervisory review,
risk management guidance and transparency and accountability. It also covers the
treatment of interest rate risk in the banking book, credit risk (stress testing, credit
concentration risk etc) operational risk, enhanced cross border risks.
The committee had identified four key principles of supervisory review:
(i) Banks should have in place a process for assessing their overall capital
adequacy in respect of their risk profile vs. maintenance of capital level
(ii) Supervisors should play a key role in reviewing and evaluating banks'
internal capital adequacy assessments and strategies. Supervisors should
also be satisfied with the banks' abilities in managing the capital adequacy
ratios and comply with the regulators' guidelines. If not satisfied with
the performance of banks in their compliance requirements, the
supervisors should take appropriate
(iii) Supervisors should ensure that banks maintain and operate above the Banking Laws and
minimum regulatory capital ratios Operations - I (135)
Banking Laws and (iv) Supervisors should intervene at an early stage, to prevent capital level
Operations - I from falling below the minimum levels required and take quick remedial
measures
Pillar III - Market Discipline:
NOTES As part of an effective risk management, banks are expected to disclose
important information. Such market discipline can contribute to a safe and sound
banking environment. These disclosures would assist various stakeholders to review
and understand the status of the banks' operations and strategies in a competitive
business environment. These disclosures would assist the investors to make their
investment decisions

9.7 Credit Risk Management

CHECK YOUR Credit risk arises when one of the counter parties fails to fulfill the obligation
PROGRESS to settle the payment or repay the borrowed amount. It is also called as default risk
and/or settlement risk.
What is Credit Risk Identification of credit risk: Close monitoring of operations in operating
Management? loan account like working capital finance, cash credit and overdraft accounts would
assist the bank to identify the risk based on the signals and warnings from the
manner in which the account is being operated. Also non submission of stock
statements, wrong information provided in stock statements, regular inspections of
stocks, and review of market reports are essential tools to identify the credit risk.

Mitigation of Credit Risk:

Credit Risk can be mitigated if the banks follow certain norms like:
(a) Adherence to KYC norms: Clear identity of the borrower and the
borrowing company, and the nature of business model
(b) Credit Appraisal: The loan proposals should be considered as per bank's
loan policy and guidelines of the Reserve Bank of India and other directives. The
credit limits (both fund based as well as non-fund based) should be fixed after due
assessment of many risks associated with the type of borrower, nature of industry
and other factors. Such limits should be subject to sufficient margin and appropriate
collateral requirements to safe guard the banks' interests. Regular monitoring of
the loan accounts should be an integral part of effective risk management system.
Respecting the credit limits and allowing the clients to operate within the credit
limits and ensuring other terms and conditions of the credit sanction, and adherence
to the exposure norms as per regulators' guidelines would assist the banks to manage
the credit risks. Risk based pricing of loans and advances and credit rating can be
used as an effective tool as part of credit management.

Credit Risk measurement - Basel II Norms

The risk which arises on account of default is associated with almost any
financial transaction. BASEL-II provides two options for measurement of capital
charge for credit risk
1. Standardized Approach (SA) - Under the SA, the banks use a risk-
weighting schedule for measuring the credit risk of its assets and off-balance sheet
positions. A risk weight of 100% indicates that an exposure is included in calculation
of assets for full value, by assigning risk weights based on the rating assigned by
the external credit rating agencies.
Banking Laws and
2. Internal Rating Based Approach (IRB) - The IRB approach, on the
(136) Operations - I other hand, allows banks to use their own internal ratings of counterparties and
exposures, which permit a finer differentiation of risk for various exposures and Risk Management
hence delivers capital requirements that are better aligned to the degree of risks. in Banks

The IRB approaches are of two types:

NOTES
(i) Foundation: Under this method banks estimate the risk of default or the
probability of default associated with each borrower.
(ii) Advanced: Under this method banks are allowed to have additional
internal capital to assess additional risk factors.

9.8 Liquidity and Market Risk Management

As explained earlier, one of the important risks faced by banks is the liquidity
risk. The banks' treasury handles the liquidity management through money market
and forex market operations; hence a careful strategy needs to be in place for
market related activities. CHECK YOUR
Identification of Liquidity Risk: Review of asset and liability mismatch is PROGRESS
one of the eye openers. There should be close control on the utilization of short
term funds for long term assets and vice versa, that would lead to maturity What is Liquidity and
mismatches. An effective credit monitoring and operations of the banks can reduce Market Risk
the impact of the liquidity risk. Management?
A good internal control review and online monitoring system, identification
of weakness in the systems and procedure etc, would also assist the bank to manage
the inflow and outflow of funds effectively.
Internal limits for cash management including foreign funds and an effective
reconciliation of nostro accounts are some of the measures to reduce the impact of
the liquidity risk.
The role of the treasury in managing the liquidity position is very important.
The treasury should closely watch the market movements and accordingly handle
the situations. To effectively monitor the risk, banks should set up limits for currency,
country and adhere to investment exposure norms as well. A close watch on the
macro level factors at different markets and ensuring necessary control measures
of revising exposure limits and other aspects would also assist to manage the liquidity
risk. Review and understanding the various features of the monetary policy and
quarterly review by the Central Bank (Reserve Bank of India) and appropriately
adjust the strategies would assist the banks in effectively managing the liquidity
position.

9.9 Market Risk

In a sense, the market risk arises on account of the external factors, i.e.,
market forces of demand and supply factors. Market risk arises from the adverse
movements in market price. Market risk can also be defined as the risk of losses
on account of on-balance sheet and off-balance sheet positions due to the
movements in market prices.
The market risk can be broadly recognized as: (i) Interest Rate Risk (ii)
Foreign Exchange Rate Risk (iii) Equity Price Risk (iv) Commodity Price Risk
(i) Interest Rate Risk:
One of the important factors that affect the bottom line of any bank is the
volatile movement of Interest rate. The interest rates of deposits/loans are basically
determined by the market forces (i.e., demand and supply for/ of funds). These Banking Laws and
Operations - I (137)
Banking Laws and are influenced by various factors like: (i) Government Policies (ii) Speculation (iii)
Operations - I Inflow and outflow of funds (iv) present and future commitments (v) Other factors
such as opportunities to invest in other markets etc.
The risk that an investment's value will change is due to a change in the
NOTES absolute level of interest rates, in the spread between two rates, in the shape of the
yield curve or in any other interest rate relationship. Such changes usually affect
securities inversely and can be reduced by diversifying (investing in fixed-income
securities with different durations) or hedging (e.g. through an interest rate swap).
(ii) Exchange Rate Risk:
The price movement in terms of foreign exchange transactions (deals) is
called the exchange rate risk. The exchange rate movement is mainly felt in case
of the floating exchange rate system (price/exchange rate is decided by the demand
and supply factors). As the markets are wide spread and the exchange rate
movement is so quick and moves either way (up and down), it is difficult to assess
the market movements when it is very volatile. The volatility in the exchange rates
movement are due to various factors such as the Government and Regulators'
policies, speculation, forecasting, markets operating in different time zones almost
on 24 x7 basis etc.
The market risk positions necessitate a bank to maintain the capital for
calculation of capital adequacy ratio is:
(i) The risks associated with the interest related instruments and equities
in the trading book of the banks and
(ii) Foreign exchange risk (including exposures in precious metals)
throughout the bank, both in banking and trading book*
Banking book:
The banking book comprises assets and liabilities, which are contracted
basically on account of relationship or for steady income and statutory obligations
and are generally held till maturity.
Trading book:
Investments held for generating profits on the short term differences in
prices/yields, Held for trading (HFT) and Available for sale (AFS) category constitute
trading book.
Market risk can be assessed/measured by various analysis such as scenario
analysis, trend and stress analysis
Scenario Analysis:
Scenario Analysis is a method in which the earnings or value impact is
computed for different interest rate scenarios. It is the process of estimating the
expected value of a portfolio after a given period of time, assuming specific changes
in the values of the portfolio's securities or key factors that would affect security
values, such as changes in the interest rate.
Stress Analysis (testing):
This is used to evaluate a bank's potential vulnerability to certain unlikely
events or movements in financial variables.
The vulnerability is usually measured with reference to the bank's
profitability and /or capital adequacy
Duration Analysis, measures the price volatility of fixed income securities.
It is often used in the comparison of interest rate risk between securities with
different coupons and different maturities. It is defined as the weighted average
time to cash flows of a bond where the weights are nothing but the present value
Banking Laws and of the cash flows themselves. It is expressed in years. The duration of a fixed
(138) Operations - I
income security is always shorter than its term to maturity, except in the case of Risk Management
zero coupon securities where they are the same. in Banks
Market Risk - Basel II norms:
Market risk is defined as the risk of loss arising from movements in market
prices or rates away from the rates or prices set out in a transaction or agreement. NOTES
The capital charge for market risk as per the Basel norms can be estimated by two
methods viz., Standardized Measurement Method and internal risk management
model.
The Standardized Measurement Method:
This method, currently implemented by the Reserve Bank, adopts a 'building
block' approach for interest-rate related and equity instruments which differentiate
capital requirements for 'specific risk' from those of 'general market risk'. The
'specific risk charge' is designed to protect against an adverse movement in the
price of an individual security due to factors related to the individual issuer. The
'general market risk charge' is designed to protect against the interest rate risk in
the portfolio. In the Standardized Approach, there are two ways to measure market CHECK YOUR
risk i.e., duration method and maturity method. Under the duration method banks PROGRESS
can calculate the interest rate risk, by calculating the price sensitivity, of each
position separately. Further the measurement of capital charge for market risks What is Equity Price
should also include all interest rate derivatives and off-balance sheet instruments in
Risk?
the trading book. Foreign exchange open positions and gold open positions are also
to be considered for capital charge as per Basel norms and the Reserve Bank of
India guidelines.
Banks should strictly follow the Reserve Bank of India's guidelines in
classification of securities as Held for Trading, Available for Sale etc., and accordingly
assign risk weights. Banks should also assess their trading books and assign risk
weights as per the Reserve Bank guidelines
Proper risk management and internal control assist organizations in making
informed decisions about the level of risk that they want to take and implement the
necessary controls to effectively pursue their objectives.
Risk management and internal control are therefore important aspects of
an organization's governance, management, and operations. Successful
organizations integrate effective governance structures and processes with
performance focused risk management and internal control at every level of an
organization and across all operations.
However, risk management and internal control are not objectives in
themselves. They should always be considered when setting and achieving
organizational objectives and creating, enhancing, and protecting stakeholder value
Value at Risk:
Market risk can be measured through this tool called "Value -at- Risk"
(VaR). .VaR is a method for calculating and controlling exposure to Market Risk.
It is a single number (currency amount) which estimates the maximum expected
loss of a portfolio over a given time horizon (holding period) and at a given
confidence level. It is measured in three variables: the amount of potential loss, the
probability of that amount of loss and the time frame.

9.10 Equity Price Risk

Equity price risk is the risk that the fair value of equities decreases as a
result of changes in the levels of equity indices and the value of individual stocks.
Each Group subsidiary has in place appropriate strategies, risk management Banking Laws and
Operations - I (139)
Banking Laws and and reporting processes in respect of the risk characteristics of equity investments.
Operations - I Each subsidiary company ensures that its valuation methodologies are appropriate
and consistent, and assesses the potential impact of its methods on profit calculations
and allocations mutually agreed between that subsidiary and its partners. Further,
NOTES each subsidiary has defined and established appropriate exit strategies and risk
management and reporting processes in respect of its equity investment activities

9.11 Commodity Price Risk

It is the threat that a change in the price of a production input will adversely
impact a producer who uses that input.
Commodity production inputs include raw materials like cotton, corn, wheat,
oil, sugar, soybeans, copper, aluminum and steel. Factors that can affect commodity
prices include political and regulatory changes, seasonal variations, and weather,
technology and market conditions. Commodity price risk is often hedged by major
CHECK YOUR
consumers. Unexpected changes in commodity prices can reduce a producer's
PROGRESS
profit margin, and make budgeting difficult.
What is Commodity Fortunately, producers can protect themselves from fluctuations in
commodity prices by implementing financial strategies that will guarantee a
Price Risk?
commodity's price (to minimize uncertainty) or lock in a worst-case-scenario price
(to minimize potential losses). Futures and options are two financial instruments
commonly used to hedge against commodity price risk
Other Important Risks: Mismatch Risk (Gap Risk):
Banks as important players in the financial sector acquire funds in the
form of deposits from public (individuals/ corporates) and deploy them to (individuals/
corporates) as loans and advances. The funds accepted/borrowed are reflected as
liabilities and the funds deployed/lent/invested appears as assets in the balance
sheets. Depending upon the business model, the liabilities and assets will have a
mismatch or gap between them. In case of Foreign Exchange Operations, the
Foreign Exchange dealer's position (exposure) in various currencies arises due to
the purchase and sale of foreign currencies in different markets, and for different
maturities. The mismatch in maturities between purchases/sales creates a gap.
These gaps can be classified based on the time period of maturity (due dates).
Therefore, to cover these (exposures) open positions banks need to buy or sell/
borrow or lend in the market, depending upon the price of currencies (exchange
rates) and interest rates.

9.12 Cross Border Risk

Another risk which is exclusively applicable to foreign exchange
transactions is the cross border risk. This type of risk is also known as country risk/
sovereign risk. Foreign Exchange markets operate on 24X7 basis almost
continuously. Obviously, all centers do not operate simultaneously and hence results
in time zone difference and that leads to risks associated with various centers
which is popularly called as cross border risk.

9.13 Country Risk:

It is a risk in which a foreign entity, private or sovereign may be unwilling
or unable to fulfill its foreign obligations for reasons beyond the usual risks, in
Banking Laws and respect to all lending and investments.
(140) Operations - I
 Risk Management
9.14 Country Risk Management System (CRMS) in Banks

For an effective CRMS, as per the guidelines of the Reserve Bank of

India, banks have to adopt the following. Some (a) Strict adherence to the "Know
NOTES
Your Customer" (KYC) principle in international transactions (b) Country risk factor
should be given special attention while evaluating the counterparty risk (c) All
exposures funded, non funded from domestic as well as international centers needs
to be included while determining the country limits
The Statutory Auditors have to audit the country risk exposures of the
bank as at the end of the year. In addition to the auditing being carried out by the
Statutory Auditors, banks have to make necessary provisions for country risk
exposures and should disclose them as part of the 'notes to account' of the balance
sheet and report to the Reserve Bank of India as part of DBS return.
In respect of CRMS, the funded, non -funded and indirect exposures would
include the following items: Some examples:

Direct Exposure - funded: CHECK YOUR

PROGRESS
(i) Cash balances - Foreign currency, if any held by branches
(ii) Bank balances and deposit placements: Covers the bank balances and What is CRMS?
placements with banks incorporated outside India
(iii) Loans and Advances: Loans against NRI deposits exceeding the deposit
amount, Travellers' cheques purchased
(iv) Overdrafts in Vostro accounts etc.

Direct Exposure - non funded:

(i) Letters of Credit: Exposures on account of Letters of credit issued by
branches on behalf of constituents resident outside India
(ii) Guarantees: Exposures on account of guarantees issued by branches
on behalf of entities resident outside India
(iii) Confirmed LCs issued by foreign banks etc.,
Short term country risk exposures are those exposures which have
contractual maturity up to 179 days.

9.15 Operational Risk

In banks, the risks which arise out of the failure in internal systems and
procedures, internal control system and/or human and system errors, and other
internal/ external factors like non compliance of regulatory and legal frame work,
frauds, misappropriation etc., One or more of the above mentioned risks are
collectively called as the "Operational Risk".
Some Examples of Operational Risks
Information Technology Risk:
Banks in India are well supported by the Information Technology to carry
out their banking business and operations.
This has increased the banks' operational risk. The risks associated with
IT are: Error Risk, Fraud Risk, Interruption Risk etc., In case of weak IT controls
and non adherence to the laid down policies and procedures, the computerized
systems could be exposed to unauthorized access. Pre acceptance tests if not
Banking Laws and
properly carried out can lead to issues which can be termed as operational risk on
Operations - I (141)
Banking Laws and account of IT. If the computerized control (both around the computer system and
Operations - I through the computer system) is not properly ensured, it can lead to a situation of
fraudulent activities. Failure on the part of the management to ensure regular testing
of disaster management control, in case of emergency, might increase the risks.
NOTES Hence importance should be given and care should also be exercised by having a
proper operational risk management with special reference to the Information
Technology.

9.16 Legal Risk

With the changing economic scenario, banks are not only exposed to risks
associated with the domestic markets, but also to international markets as well.
More and more banking activities across borders, banks have to comply with more
than one regulatory authority and also a number of legal frame work of international
importance. The cross border or country specific legal requirements needs to be
CHECK YOUR properly interpreted and understood and applied in the case of international trade
PROGRESS and finance. The money laundering has become an important international issue;
banks have to be careful in its operations. Banks should appoint international legal
Describe legal risk? firms to handle their legal compliance to avoid legal risks.
The Basel Committee defines this risk as "The risk of loss arising out of
inadequate or failed internal processes, people and systems, or from external events".
Banks have to make capital allocation for operational risks as well.

The revised BASEL II framework offers the following three approaches

for estimating capital charges for operational risk:
(1) The Basic Indicator Approach (BIA): This approach sets a charge for
operational risk as a fixed percentage ("alpha factor") of a single indicator,
such as the banks' gross annual revenue.
(2) The Standardized Approach (SA): This approach requires that the bank
separate its operations into eight standard business lines, such as trade
finance, corporate banking and others. The capital charge for each
business line is calculated by multiplying gross income of that business
line by a factor ("beta") assigned to that business line.
(3) Advanced Measurement Approach (AMA): Under this approach, the
regulatory capital requirement will equal the risk measure generated by
the banks' internal operational risk measurement system.
As per the guidelines of the Reserve Bank of India, banks are required to
integrate to the Basel II framework, with the Standardized Approach for Credit
Risk and Basic Indicator Approach for Operational Risk. Banks are also required
to upgrade their technology base to support implementation of Risk Assessment
and Risk Management structure to meet the requirements of the Advanced
Approaches under Basel II.

9.17 Risk Management under BASEL III

As per Basel Committee on Banking Supervision (BCBS), Basel III reforms
have been introduced to improve the banking sector's ability to absorb shocks
arising from financial and economic stress, thus reducing the risk spillover from the
financial sector to the real economy.

Banking Laws and

(142) Operations - I
Basel III norms address the following: Risk Management
(a) At micro level, through prudential regulation to strengthen the individual in Banks
banking institution's ability to handle crisis in the period of stress
(b) At macro level, through prudential regulation to address system wide
risks across banking sector as well as the pro-cyclical amplification of NOTES
these risks over a period of time
(c) Raising the quality and level of capital to ensure that the banks are
better equipped to absorb losses on both, a going concern basis and a
gone concern basis
(d) Increase the level of risk coverage of the capital framework by introducing
leverage ratio to serve as a backdrop to the risk-based capital
(e) Raise the standards for supervisory review (Pillar 2) and public
disclosures(Pillar 3)
(f) The capital buffers- capital conservation buffer and the countercyclical
buffer- are expected to protect the banking sector from the periods of
excess credit growth.
The BASEL III capital regulations continue to be based on three-mutually CHECK YOUR
reinforcing Pillars viz. minimum capital requirements, supervisory review of capital PROGRESS
adequacy, and market discipline, of BASEL II.
Describe Reporting of
In India guidelines on Basel III capital regulation have been implemented
from April 1, 2013 in a phased manner. To ensure smooth transition to BASEL III,
Banking Risk?
appropriate transitional arrangements have been made for meeting the minimum
BASEL III capital Ratios, full regulatory adjustments to the components of capital,
etc. Consequently, BASEL III capital regulations would be fully implemented as
on March 31, 2018.

Guidelines on Liquidity Coverage Ratio and Liquidity Risk Monitoring

Tools under Basel III:
The Basel III Framework on Liquidity Standards includes Liquidity Coverage
Ratio (LCR), Net Stable Funding Ratio (NSFR) and liquidity risk monitoring tools.
RBI's guidelines included enhanced guidance on liquidity risk governance, and
measurement, monitoring and reporting to the Reserve Bank on liquidity positions.
The Basel III liquidity standards were subject to an observation period/revision by
the Basel Committee with a view to addressing any unintended consequences that
the standards may have for financial markets, credit extension and economic growth.
The Basel Committee has issued guidelines on the Liquidity Coverage
Ratio and Liquidity Risk Monitoring Tools in January 2013, and is in the process of
finalizing the NSFR and disclosure requirements. The LCR is to be implemented
from January 1, 2015 and the NSFR from January 1, 2018. The Reserve Bank will
issue the final guidelines on Basel III liquidity standards and liquidity risk monitoring
tools, taking into account the revisions by the Basel Committee.

9.18 Reporting of Banking Risk

Accurate, complete and timely data is a foundation for effective risk
management. However, data alone does not guarantee that the board and senior
management will receive appropriate information to make effective decisions about
risk. To manage risk effectively, the right information needs to be presented to the
right people at the right time. Risk reports based on risk data should be accurate,
clear and complete. They should contain the correct content and be presented to
Banking Laws and
the appropriate decision-makers in a time that allows for an appropriate response. Operations - I (143)
Banking Laws and To effectively achieve their objectives, risk reports should comply with the following
Operations - I principles.
Accuracy - Risk management reports should accurately and precisely convey
aggregated risk data and reflect risk in an exact manner. Reports should be
NOTES reconciled and validated.
Comprehensiveness - Risk management reports should cover all material risk
areas within the organization. The depth and scope of these reports should be
consistent with the size and complexity of the bank's operations and risk profile, as
well as the requirements of the recipients.
Clarity and usefulness - Risk management reports should communicate
information in a clear and concise manner. Reports should be easy to understand
yet comprehensive enough to facilitate informed decision-making. Reports should
include meaningful information tailored to the needs of the recipients.
Frequency - The board and senior management (or other recipients as appropriate)
should set the frequency of risk management report production and distribution.
Frequency requirements should reflect the needs of the recipients, the nature of
the risk reported, and the speed, at which the risk can change, as well as the
importance of reports in contributing to sound risk management and effective and
efficient decision-making across the bank. The frequency of reports should be
increased during times of stress/crisis.
Distribution - Risk management reports should be distributed to the relevant parties
while ensuring that confidentiality is maintained.

9.19 Key concepts

As per Basel Committee on Banking Supervision (BCBS), Basel III reforms
have been introduced to improve the banking sector's ability to absorb shocks
arising from financial and economic stress, thus reducing the risk spillover from the
financial sector to the real economy.
A Risk arises on account of an uncertain event, which might result in a
loss or gain to the parties associated with such risk. Even though the risk is an
independent event, invariably risks are interlinked in the sense; one risk may lead
to other risks as well.

9.20 Summary
l Banks, being an important financial intermediary, are associated with many
risks.
l It is obvious that despite best efforts banks cannot avoid or completely
eliminate the risks.
l However through an effective risk management system, they can reduce
the impact of risks if not avoid the risks.
l As per the Basel norms, banks can integrate the three pillar concepts with
an effective management assessment and control, coupled with a very good
supervision and market discipline banks can overcome the risks to a greater
extent.
l Banks risk management system needs to address various aspects like
identification, evaluation, monitoring and measuring the risks.
l Banks should ensure that their Risk Management System should be based
Banking Laws and on the Basel Norms and the Reserve Bank of India's guidelines.
(144) Operations - I
 Risk Management
9.21 Exercise in Banks

Fill in the blanks

1. Risk management policies should be approved by the _________. It should
cover all the required guidelines and directives of the regulators and applicable NOTES
legal frame work.
(Board, Chairman, Customers)
2. ________________ is a strategic decision making body, formulating and
overseeing the function of asset liability management (ALM) of a bank.
(Credit Risk Management Committee, Asset-Liability Management
Committee (ALCO), Basel Committee)
3. The __________ on Banking Supervision (BCBS) is a committee which
was set up by the Central Bank Governors of a group of ten countries, to
address international issues relating to the banking supervision.
(Audit Committee, Credit Risk Management Committee, Basel Committee)
4. _________ arises when one of the counter parties fails to fulfill the obligation
to settle the payment or repay the borrowed amount. It is also called as
default risk and/or settlement risk.
(Operational Risk, Liquidity Risk, Credit Risk)
5. ___________can also be defined as the risk of losses on account of on-
balance sheet and off-balance sheet positions due to the movements in market
prices.
(Market Risk, Operational Risk, Liquidity Risk)
6. Interest Rate Risk, Foreign Exchange Rate Risk, Equity Price Risk,
Commodity Price Risk are the components of _____________.
(Market Risk, Operational Risk, Liquidity Risk)
7. _________ is the risk that the fair value of equities decreases as a result of
changes in the levels of equity indices and the value of individual stocks.
(Equity Price Risk, Credit Risk, Country Risk)
8. In banks, the risks which arise out of the failure in internal systems and
procedures can be called as ____________.
(Liquidity Risk, Market Risk, Operational Risk)
9. Accuracy, Comprehensiveness, Clarity and usefulness, Frequency, Distribution
are the principles we use to prepare ______.
(Risk Report, Bank Report, Audit Report)
10. _________ reforms have been introduced to improve the banking sector's
ability to absorb shocks arising from financial and economic stress, thus
reducing the risk spillover from the financial sector to the real economy.
(Basel I, Basel II, Basel III)

[ANS: 1)Board 2)Asset- Liability management committee 3)Basel

Committee 4)Credit Riskk 5)Market risk 6)Market risk 7)Equity Price
Risk 8)Operational Risk 9)Risk Report 10)Basel III]

9.22 Further Readings & References

1. M.L.Tannan, revised by : Banking Law and Practice, Wadhwa & Company,
Nagpur C.R. Datta & S.K. Kataria
2. A.B. Srivastava and : Seth's Banking Law, Law Publisher's India (P) Limited
K. Elumalai
3. R.K. Gupta : BANKING Law and Practice in 3 Vols. Modern Law Publications.
4. Prof. Clifford Gomez : Banking and Finance - Theory, Law and Practice, PHI
Learning Private Limited Banking Laws and
5. J.M. Holden : The Law and Practice of Banking, Universal Law Publishing. Operations - I (145)
Banking Laws and
Operations - I UNIT 10
ELECTRONIC BANKING AND
NOTES
IT IN BANKING
Structure
10.0 Introduction
10.1 Objective
10.2 Communication networks in banking system
10.3 E-Banking
10.4 Internet
10.5 World Wide Web (WWW)
10.6 Electronic Fund Management
10.7 Electronic Clearing System (ECS)
10.8 Real Time Gross Settlement (RTGS)
10.9 National Electronic Funds Transfer (NEFT)
10.10 Indian Financial System Code (IFSC)
10.11 Automated Teller Machines (ATMs)
10.12 Internet Banking
10.13 Core Banking Solutions (CBS)
10.14 Computerization of Clearing of Cheques
10.15 Cheque Truncation System (CTS)
10.16 Key concepts
10.17 Summary
10.18 Exercise
10.19 Further Readings & References

10.0 Introduction
The 20th century witnessed many changes to the International Trade,
Banking and Finance on account of new revolution in the Information and
Communication Technology. Banks across nations have been moving to the e -
commerce and e-banking environment. On account of these changes banks are
able to provide more flexible banking options for their clients, by offering many
innovative products and services through ATMs, Credit and Debit Cards, Internet
Banking ,Core Banking Solutions etc., While quicker and faster services like
convenient banking, anywhere banking, 24 x7 virtual banking are offered, coupled
with quick remittance and funds transfers, on the other hand banks are also exposed
to the cyber crimes, on account of more usage of computers and IT enabled services.
Further, in view of cross border transactions, if proper control is not
exercised, banks can be used as channels for money laundering as well.
Over the years, especially in the later part of the 20th century, the Indian
Banking Sector has undergone fast growth and with the advent of technological
changes, Indian banks are adopting to the new environment. The two successive
Committees on Computerization (Rangarajan Committees) were responsible for
bank computerization in India. Over the years led by the initiatives of the Reserve
Banking Laws and Bank of India, banks in India have witnessed lot of changes into their banking
(146) Operations - I operations duly supported by IT and communication revolution.
 Some important areas where the IT plays important roles are: Funds Electronic Banking and
Transfer mechanism: ECS, EFT, RTGS, NEFT Clearing House operations: MICR, IT in Banking
CTS Innovative on line e- banking services: Tele banking, Mobile banking, SMS
banking, Credit/ Debit Cards, ATMs, Internet banking, Core Banking Solutions,
etc. NOTES

10.1 Objectives
After reading this unit, you should be able to:
- Understand the significance of the E banking in today's fast changing
business environment
- Appreciate the innovations by banks, on account of revolutions in
information and communication technology
- Be cautious in recognizing cyber crimes and frauds and can be pro active
to handle such risks
- Look forward to the future scenario of Ecommerce. E banking and other
technological innovations CHECK YOUR
PROGRESS

10.2 Communication networks in banking system Describe E-Banking?

As per the recommendations of the Saraf Committee, the Reserve Bank
of India has set up a country wide data communication network for banks linking
major centers of the country, known as INFINET (Indian Financial Network) and
this network uses satellite communication with very small aperture terminals
(VSATs) as earth stations. VSAT network is a single closed user group network
for the exclusive use of banks and other financial institutions.
The VSATs are owned by individual banks and the RBI. The hub is owned
by the RBI and the Institute for Development and Research in Banking Technology
(IDRBT). Satellite services based on VSAT technology can establish reliable links
to all sites. The central hub monitors and controls the flow of network traffic.

10.3 E-Banking
Electronic banking, also known as electronic funds transfer (EFT), is simply
the use of electronic means to transfer funds directly from one account to another,
rather than by cheque or cash. You can use electronic funds transfer to:
l Have your paycheck deposited directly into your bank or credit union checking
account.
l Withdraw money from your checking account from an ATM machine with a
personal identification number (PIN), at your convenience, day or night.
l Instruct your bank or credit union to automatically pay certain monthly bills
from your account, such as your auto loan or your mortgage payment.
l Have the bank or credit union transfer funds each month from your checking
account to your mutual fund account.
l Have your government social security benefits check or your tax refund
deposited directly into your checking account.
l Buy groceries, gasoline and other purchases at the point-of sale, using a
check card rather than cash, credit or a personal check.
l Use a smart card with a prepaid amount of money embedded in it for use Banking Laws and
Operations - I (147)
Banking Laws and instead of cash at a pay phone, expressway road toll, or on college campuses
Operations - I at the library's photocopy machine or bookstores.
l Use your computer and personal finance software to coordinate your total
personal financial management process, integrating data and activities related
NOTES to your income, spending, saving, investing, recordkeeping, bill-paying and
taxes, along with basic financial analysis and decision making.

10.4 Internet
The internet is a global network of networks. Computers with internet
links can allow users to exchange data, information, messages, files, etc, with other
computers across the globe through internet connectivity.
Some of the important services available on internet are: E-mail: Most
popular and widely used application. Messages can be sent and received to/from
any place in very quick time. It is user friendly and cost effective as well. Internet
access connects individual computer terminals, mobile devices, and computer
networks to the Internet, enabling users to access Internet services, such as email
CHECK YOUR and the World Wide Web. Internet service providers (ISPs) offer Internet access
PROGRESS through various technologies that offer a wide range of data signaling rates (speeds).
Consumer use of the Internet first became popular through dial-up Internet
Describe WWW? access in the 1990s. By the first decade of the 21st century, many consumers in
developed nations used faster, broadband Internet access technologies.

10.5 World Wide Web (WWW)

This facility collates internet related resources and makes available the
information. The access to this site assists user to source out a large variety of
information.
Banks uses internet and web sites (banks' own web sites) to market their
products and services. These platforms also allow banks to offer online banking
facilities and can be used for posting their financial results and information to
customers.
The World Wide Web is like a huge electronic magazine with its pages
stored on many computers (called "servers") around the world. Pages on the web
are connected by links called "hypertext". Each hypertext link jumps to another
page... so unlike reading a book where one page follows another in sequence, on
the World Wide Web one can follow a web of links to visit the information he is
interested in.
What is termed "surfing the web" is clicking through one page to another -
from hypertext link to hypertext link. One can go on an endless adventure from
web page to web page, turning back at any time, or going off in tangents.
To access the World Wide Web one needs, a computer, a modem (or some
other connection device), a phone line, and software called a "browser"... and an
account with an Internet Service Provider. The browser itself is a relatively simple
piece of software that interprets a computer code called HTML - or hypertext
mark-up language. Most web pages are written in HTML - the browser merely
interprets the HTML's instructions to display the text, pictures, play sounds or run
animation. The two most popular browsers are Firefox and Microsoft's Internet
Explorer.

Banking Laws and

(148) Operations - I
 Electronic Banking and
10.6 Electronic Fund Management IT in Banking

Banking operations over the years and decades have witnessed many
changes and have been adopting from time to time new innovations. The
NOTES
technological revolution especially in the Information and Technology front has
changed the functioning of banks. In today's globalized competitive business
environment banks are trying to have the competitive edge by using the latest
technology to cut down turnaround time, cut costs and increase efficiency. "e
Banking" through many innovative products and services has revolutionized banking
operations.
IT revolution has paved way for banks to implement different systems to
handle funds management in banks. This methodology is collectively recognized as
Electronic Fund Management.

10.7 Electronic Clearing System (ECS)

CHECK YOUR
One of the earliest electronic forms of funds transfer is the Electronic
PROGRESS
Clearing System. ECS is a retail funds transfer system to effect payments (utility
bills, dividends, interest, etc) ECS helps corporates, government departments, public
sector undertakings, utility service providers to receive and/or pay bulk payments.
Describe ECS?
ECS is divided into ECS (credit) and ECS (debit)
ECS - important aspects/ features
On receipt of the required mandate, the funds (payments/ receipts) can be
handled by a bank through ECS. ECS (debit) is generally used by utility companies
like electricity companies, telephone companies and other to receive the bill
payments directly from bank accounts of their clients. Instead of payment of utility
bills by means of cash or cheque payments, an individual or a company can make
payment through ECS. In case the company has the facility of payment through
ECS, the client can give a mandate to the company to receive the utility bill amount
from his bank account directly. The utility company (service provider) based on
the ECS mandate given by the client, would advise the client's bank to debit the bill
amount to the client's account on the due date (or on a any date before the due
date as per the client's request) and transfer the amount to the company's own
bank account. Similarly, ECS (Credit) can facilitate payment to various clients like
dividend warrants, maturity values of Annuities.

10.8 Real Time Gross Settlement (RTGS)

One of the important IT revolutions in Indian Banking Scenario was the
implementation of the Real Time Gross Settlement (RTGS) system by the Reserve
Bank of India. With the changing scenario from manual environment to electronic
mode, banks started to use faster, safer and efficient methods to transfer funds.
In this regard, two important and popular electronic funds transfer systems
are Real Time Gross System (RTGS) and National Electronic Funds Transfer System
(NEFT) RTGS is an electronic payment system, where payment instructions are
processed on a 'continuous' or 'REAL TIME' basis and settled on a 'GROSS' or
'individual' basis without netting the debits against credits. In India, RBI introduced
this system and the system is functioning well. The payments so effected are 'final'
and 'irrevocable'.
The settlement is done in the books of the central bank (RBI). The RTGS
Banking Laws and
system allows transfer of funds across banks on a real time (immediate) basis.
Operations - I (149)
Banking Laws and Each participant bank needs to open a dedicated settlement account for putting
Operations - I through its RTGS transactions. Not only does it allow transfer of funds, it also
reduces the credit risk. Both customers and banks can transfer funds monies the
same day at regular intervals within the banking hours.
NOTES
RTGS: Special features:
(a) Real Time Gross Settlement helps banks to settle interbank and forex
settlements
(b) It also helps banks in handling big ticket funds transfers
(c) Since RTGS it is routed through RBI platform, the credit risk is minimized
(this is one of the main advantages in settlement of funds)
(d) Unlike in case of cheque clearance, the drawer of the cheque cannot
enjoy the float time (the date of issuance of cheque and the date on
which it is received in inward clearing and debited by his banker)
However, in the case of RTGS, the remitter's account is debited first
and then only the funds are transferred
(e) If all relevant details such as the beneficiary's name, account number,
CHECK YOUR IFSC code of the receiving branch, name of the beneficiary bank, etc.,
PROGRESS are correctly furnished it would assist the remitting bank to effect the
transfer quickly (f) As the name RTGS suggests, the transfer mechanism
Describe NEFT? works on real time and, therefore, the beneficiary branch/bank should
receive the funds immediately. The beneficiary's branch/bank should
give credit to the beneficiary's account immediately or latest within 2
hours of receiving the funds transfer message.
However, in case the funds cannot be credited for any reason, such funds
should be returned to the originating branch within two hours. In such a situation,
as soon as the money is returned, the remitting bank should reverse the original
debit entry in the client's (remitter's) account. This system is applicable between
banks/branches who are on Core Banking Solutions (CBS)

10.9 National Electronic Funds Transfer (NEFT)

NEFT is a system similar to RTGS with certain differences. RTGS handles
big ticket transactions, whereas NEFT handles smaller size transactions. Most
branches are using this facility to transfer funds in an efficient manner.
Once the applicant for the transfer of funds furnishes full and correct
details (correct account details means correct name of the beneficiary, the correct
account number, the branch and bank of the beneficiary, and the correct IFS code,
etc.) funds can be transferred to the beneficiary's account by the remitting bank.
Transfer of funds through NEFT is safe, quick. It reduces the paper work and is
cost effective. NEFT is an innovative electronic media for effecting transfer of
funds. Special features of NEFT are:
1. NEFT is a funds transfer system which enables a customer of a bank to
transfer funds to another customer of another bank having account with
any participating bank
2. NEFT allows both intra and inter-bank funds transfer within a city and
across cities
3. Since it is in the form of e transfer, without any physical movement of
instruments, funds can be transferred quickly
4. The beneficiary customer gets funds in his account on the same day or
at the earliest on the next day depending upon the time of settlement
5. Both the originating and destination bank branches should be on NEFT
Banking Laws and
(150) Operations - I
platform
 6. The correct details of IFSC, beneficiary's name, account numbers, etc., Electronic Banking and
should be furnished to the originating bank. IT in Banking
7. The originating bank branch can keep track of the status of the NEFT
transaction.
8. In case for any reason the destination branch is not able to afford credit NOTES
to the beneficiary's account, destination branch/bank have to return the
funds to the originating bank within two hours of completion of the batch
through which the transaction was processed
9. It is not only easy method of transfer of funds, but also enables the
remitters to have user friendly and cost effective transfer of funds

10.10 Indian Financial System Code (IFSC)

Unique features of Indian Financial System Code or IFSC Codes can be
explored for many banking transactions and other associated factors with whom
they are keenly linked with. Are you a SBI account holder? If yes then you must
obtain IFSC Code of SBI for your own benefits. One can Enjoy pleasurable banking CHECK YOUR
through suitable use of IFSC Code SBI and linking it with the rest banks. PROGRESS
All banks have their unique IFSC Codes. One should be aware of IFSC
Code ICICI bank if he is one of its customers. Describe IFSC?
With the IFSC Code of SBI one can easily monitor the account from
anywhere in the world and transfer funds through various sources. Getting access
to IFSC Code SBI of a particular branch should be registered online in the banking
list for adding beneficiaries. If IFSC Codes and other details are not available then
one can't transfer funds online.
IFSC is an alpha-numeric code that identifies a bank-branch participating
in the RTGS/NEFT system. IFSC has 11 digit code and the first four alpha
characters represents the bank, the 5th code is 0 (zero), which is reserved for
future use and the last six digits are numeric characters represents the branch.
Correct IFSC code is essential for identifying the beneficiary's branch and bank as
destination for funds transfers. E.g. Syndicate Bank Cuffe Parade Branch, Mumbai-
SYNB0005087

10.11 Automated Teller Machines (ATMs)

ATMs are used as a channel for cash management of individual customers.
ATMs can be accessed by ATM card, debit or credit cards. To have access the
customer (the card holder) needs to use his Personal Identification Number (PIN)
issued by his/her banker and access password. ATMs generally used for cash
deposit and withdrawals, they can also be used for payment of utility bills, funds
transfer thereby ATMs serve as a channel for electronic funds management.
Requests for new cheque book and statement of accounts can also be given through
ATMs.
White Label ATMs- RBI has vide notifications dated 20th June, 2012,
permitted non-banking entities to set up or start ATMs which are called White
Label ATMs (WLA). From such ATMs customers of any bank will be able to
withdraw money, takeout statement, change PIN etc. These WLAs will not display
logo of any bank. However, WLA operator has been permitted to display
advertisements, and offer value added services as per regulations in force.
While WLA operator is entitled to receive a fee from the banks for use of
ATM resources by their customers, WLAs are not permitted to charge Bank Banking Laws and
customers directly for use of WLA. Operations - I (151)
Banking Laws and
Operations - I 10.12 Internet Banking
Internet banking one of the popular e-banking modes has changed the
banking operations and offer virtual banking services to the clients on 24 x 7 basis.
NOTES
It is also called as convenient banking, since the customer (account holder) can
have access to his bank account from anywhere at any time, through the bank's
web site. The customer is allowed online access to account details and payment
and funds transfer facilities. Net banking services of a bank can be accessed
through a Personal Identification Number (PIN) and access password as in the
case of ATMs. In net banking the advantage for the bank customer is that funds
can be transferred from the client's bank account to another account with the
same bank or another bank through NEFT/RTGS. Another method of funds transfer
facility is online payment of taxes. Bank customer can pay various taxes like income
tax, service tax, etc.; Net banking can be used as a channel by the customer to pay
the utility bills (electricity bills, telephone bills, etc) on line.
Customers can make use of net banking to pay the insurance premiums
and similar other payments.
CHECK YOUR
PROGRESS
10.13 Core Banking Solutions (CBS)
Describe CBS?
Core Banking Solutions has helped banks to offer better customer service.
It has also reduced the time and increased the efficiency. The Core Banking
Solutions mainly work on the support of effective communication and good
information technology. It is on account of merger of communication technology
and information technology which enables the banks to offer core banking needs
of the clients.
Core Banking Solutions are computer based banking applications (software)
which works on a platform. The computer software handles the different functions
of the bank like, recording of transactions, updating the balances in the accounts
based on the type of transactions, calculate interests and application of interest,
charges etc., The software is installed in the branches and the computer systems
are interconnected with a main computer server though communication lines
(telephones, satellite, internet, fibre optical) CBS is a back end system, and it
processes daily banking transactions and updates the records accordingly. CBS
helps the clients to operate their accounts from any CBS branch. CBS branch
assist customers to handle their funds transfers in a quick turnaround time. It also
assists the client to withdraw and deposit funds in other branches apart from the
parent branch, where he maintains his account.
Data Warehousing- A Data Warehouse or Enterprise Data Warehouse
(DWH/EDW) is a database used for reporting and data analysis. It is a central
repository of data which is created by integrating data from one or more separate
sources. DWH store current as well as historical data and are used for creating
trending reports for use by senior management. The data stored in the warehouse
are uploaded from the operation systems. The main source of data is cleaned,
transformed, catalogued and made available for use by the managers for data
mining, online analytical processing and decision support.

10.14 Computerization of Clearing of Cheques

Over the years Reserve Bank of India as a facilitator has been playing a
vital role in the implementation of innovative systems, to enable banks not only to
Banking Laws and function effectively but also to offer better customer service. RBI is in charge of
(152) Operations - I
the clearing house and clearing operations. It has always taken lead to introduce Electronic Banking and
new systems to speed up clearing process as well to reduce the turnaround time in IT in Banking
clearance of funds. Computerization of clearing operations was the first major
step initiated by RBI, over the years RBI has been upgrading the system with new
changes. To overcome the increasing volume of cheques through the clearing NOTES
mechanism, RBI has fully automated the clearing house operations. This is based
on the Magnetic Ink Character Recognition technology; RBI upgraded the clearing
functions with new set of MICR cheques. Under this new system, cheques should
have MICR code consisting of 9 digits. Each cheque would have the unique 9 digit
MICR code along with the cheque number.

MICR code consists of 9 digits as:

- First three digits indicates CITY {identical to the first three digit of the
postal pin code of the CITY (For example: in case of Mumbai, it would
be 400)}
- Next three digits represents the Bank and each bank has been given a CHECK YOUR
three digit code called bank code PROGRESS
- Last three digits denote the branch code
Under this MICR system the computer program would read and sort out Describe CTS?
the cheques based on the codes, thereby, in quick turnaround time, the system is
able to handle volume.

10.15 Cheque Truncation System (CTS)

Cheques are being used as a medium for exchange of funds, which play a
key role in the funds management of customers and banks. The efficient cheque
clearing system helps in settlement of receipts and payments. Cheque
Truncation is a new system introduced in Indian Banking Scenario. It is a
system of cheque clearance and settlement between banks based on electronic
data and/or images without the need for exchange of physical cheques and negotiable
instruments like demand drafts, pay orders, dividend warrants, etc.

Cheque truncation - Special features:

- Bank customers would get their cheques realized faster
- Quick realization helps in better cash management (receivables/payables)
- In the long run, it would reduce the administrative costs for bank
- Importantly this would assist banks' in reconciliation and also reduction in
clearing frauds.

Electronic Commerce and Banking

The global e-commerce activities include the interaction of traders (buyers/
importers and sellers/exporters) with banks and counterparties, manufacturers,
service providers etc., Banks across the globe provide payments and settlements
services thereby enable the rapid growth of global e-commerce. "e marketing" or
cyber marketing is an important segment of e commerce. Salient features of internet
(e) marketing are:
Internet marketing Interconnectivity Interactivity
Information Individual preference Integrity
Internet based marketing is an important segment in e commerce. It plays
a vital role in the supply chain process of exchange of goods between the producer
and consumer. Banking Laws and
Interconnectivity: Internet is recognized as a network of networks. The Operations - I (153)
Banking Laws and search engines assist the user of the internet to have access to required information.
Operations - I For customers, the interconnectivity offered by the internet helps him/her to have
information/access to large number of diverse markets. One important feature is
that it gives information and access about international markets as well.
NOTES
Interactivity:
Internet not only allows access but also allows interface and interactivity
among users. In view of this interface, I assist both the producer/manufacturer as
well as customers to have better communication and choices. It allows the marketer
to customize and focus even on individual customers in large markets. On the
other hand the customers are also benefitted because of their interface with the
marketer, peers and different web sites to make their selection.

Information:
The availability of large number of websites on the internet enables the
customers to decide on price, choice of products, designs etc., On account of
innovative methods of marketing the customers can have access to information
covering wide range of areas.

Individual preference:
The interconnectivity, information and interface provided by the internet
network assists the customer with wide choices. Based on his/her preference and
capacity a customer can decide on his preference to choose and order.

Integrity:
With the changing time and requirements and on account of security issues
and also to safe guard the users from cyber crimes, internet provides tools to
check the authenticity of the data and its providers. In view of many fake offers &
advertisements, the internet users should be cautious. They should not provide any
sensitive information like details of PIN, passwords and other information to any
unauthorized sites, not only to safeguard their interests, but also not to allow cyber
criminals to have access to this information.

10.16 Key concepts

Electronic banking, also known as electronic funds transfer (EFT), is simply
the use of electronic means to transfer funds directly from one account to another,
rather than by cheque or cash.
ECS is a retail funds transfer system to effect payments (utility bills,
dividends, interest, etc)
Real Time Gross System (RTGS) and National Electronic Funds Transfer
System (NEFT)
10.17 Summary
l IT has revolutionized banking sector to a great extent.
l While the IT and communication technological revolutions have created good
opportunities for banks in their business expansion, they have also exposed
banks to risks associated with them.
l Banks have been able to offer virtual banking facilities to their clients and
many innovations of making services available through 24x7 basis, internet
banking and Core Banking Solutions, quicker transfer of funds through RTGS
Banking Laws and and NEFT.
(154) Operations - I
l On the other side, banks are also subject to impact of Cyber Crimes, Money Electronic Banking and
Laundering activities etc., IT in Banking
l Recognizing the importance of risks in IT, the regulators, and banks' all over
the world need to strengthen their risk management system.
NOTES

10.18 Exercise
Fill in the blanks
1. Electronic banking, also known as ____________________, is simply the
use of electronic means to transfer funds directly from one account to another,
rather than by cheque or cash.
(Electronic Fund Transfer, Emergency Fund Transfer, Express Money
Transfer)
2. IT revolution has paved way for banks to implement different systems to
handle ______ management in banks.
(system, customers, funds)
3. ECS stands for ___________
4. Full form of RTGS is__________
5. NEFT stands for____________
6. _________ is an electronic payment system, where payment instructions
are processed on a 'continuous' basis and settled on 'individual' basis without
netting the debits against credits.
(NEFT, IFSC, RTGS)
7. ________handles relatively smaller size transactions.
(NEFT, IFSC, RTGS)
8. With the _____ Code of SBI one can easily monitor the account from
anywhere in the world and transfer funds through various sources.
(NEFT, IFSC, RTGS)
9. ______ is a system of cheque clearance and settlement between banks
based on electronic data and/or images without the need for exchange of
physical cheques and negotiable instruments like demand drafts, pay orders,
dividend warrants, etc.
(CTS, RTGS, NEFT)
10. _________would assist banks' in reconciliation and also reduction in clearing
frauds.
(CTS, RTGS, NEFT)
[ANS: 1)Electronic funds transfer 2)Funds 3)Electronic Fund Transfer
4)Real Time Gross Settlement 5)National Electronic Funds Transfer
6)RTGS 7)NEFT 8)IFSC 9)CTS 10)CTS]

10.19 Further Readings & References

1. M.L.Tannan, revised by : Banking Law and Practice, Wadhwa & Company,
Nagpur C.R. Datta & S.K.Kataria
2. A.B. Srivastava and : Seth's Banking Law, Law Publisher's India (P) Limited
K. Elumalai
3. R.K. Gupta : BANKING Law and Practice in 3 Vols.Modern Law Publications.
4. Prof. Clifford Gomez : Banking and Finance - Theory, Law and Practice, PHI
Learning Private Limited
Banking Laws and
5. J.M. Holden : The Law and Practice of Banking, Universal Law Publishing.
Operations - I (155)
Banking Laws and
Operations - I UNIT 11
ETHICS AND CORPORATE
NOTES
GOVERNANCE IN BANKING
Structure
11.0 Introduction
11.1 Objectives
11.2 Ethics
11.3 Rights of people
11.4 Ethical and unethical issues
11.5 Features of Ethics
11.6 Ethical Theories and Approach
11.7 Ethics: Certain important concepts
11.8 Corporate governance ethics
11.9 Scope of Business Ethics
11.9.1 Ethics in Compliance
11.9.2 Ethical aspects in Human Resource Management
11.9.3 Ethichal aspects in Marketing Management
11.9.4 Ethical aspect in Financial Management
11.10 Desired Ethical Practices and Corporate Governance
11.11 Key Concepts
11.12 Summary
11.13 Exercise
11.14 Further Readings & References

11.0 Introduction
In today's fast growing economies, the reputation of an organization is as
much important as its market value. Added to the financial crisis, the organizations
are facing governance issues which are creating reputational risks. To overcome
these, the corporate sector is focusing on a new concept called "Corporate
Governance". Corporate governance can be referred to the overall control of the
activities of the corporation. In other words corporate governance refers to the
problem arising from the separation of control and ownership. In this unit we have
addressed the issues relating to Ethics, Corporate Governance and Corporate Social
Responsibility in banks.

11.1 Objectives
After reading this unit, you should be able to:
- know clearly about the importance of corporate governance
- Identify and appreciate the inter connectivity of
- Corporate ethics
- Corporate Governance
Banking Laws and - Corporate Social Responsibility
(156) Operations - I
 Ethics and Corporate
11.2 Ethics Governance in Banking

The word "ethics" is derived from the Greek word "ethikos" which means
character or custom. As per Chambers Dictionary "ethics" is a code of behavior
NOTES
considered correct. According to some other views, ethics is the science of moral,
moral principles and practices. Ethics also deals with the distinction between different
actions like 'good or bad'; 'correct or incorrect; 'moral or immoral'

Understanding ethics:
An individual or group of persons are influenced and guided by his/their
religious faith. Religious teachings create values in individual or group of persons.
Almost all religious practices are based on similar principles. Some of the important
guidelines of religions:
(a) Be kind to all others including animals and natural resources
(b) Be humble, modest and simple and courteous
(c) Be truthful to one's self and others
CHECK YOUR
(d) Avoid greed, lust, anger which are excesses of desire, love and annoyance PROGRESS
respectively
(e) Be content in life Describe Rights of
(f) Be happy with others' achievements/ performance people?

11.3 Rights of people

People have rights to (i) privacy (ii) information (iii) freedom-of faith, speech
(iv) practice fair trade/ professional practices (v) safety (vi) equitable treatment.
An attempt by any person to violate any of these rights is considered unethical.
Right to privacy is violated in many ways. For example: The personal data available
with researchers have led to many junk/spam mails, tele-marketing calls, etc.

11.4 Ethical and unethical issues

In practical situations, it is not always easy to determine whether a particular
issue is ethical or unethical. Based on certain perceptions and depending upon the
situations, it can be referred to as ethical or unethical. Value is the factor that
distinguishes an action as ethical or unethical.
Value and ethics:
Sincerity, trust, concern for others, keeping up the commitments, respect
for others' rights, selflessness, are some examples of Values in an individual's life.
Ethical meaning of certain terms is shown below:
Terms Ethical Concept
Right Morally
Fair Honesty
Proper Acceptable

Banking Laws and

Operations - I (157)
Banking Laws and
Operations - I 11.5 Features of Ethics
- Ethics is a conception of right or wrong conduct. Ethics tells us when
our behaviour is moral and when it is immoral. It deals with the
NOTES
fundamental human relationship, how we think and behave towards others
and how we want them to think and behave towards us.
- Ethics relates to the formalised principles derived from social values. It
deals with the moral choices that we make in the course of performing
our duties with regard to the other members of society. Hence, it is
relevant in the context of a society only.
- Ethical principles are universal in nature. They prescribe obligations and
virtues for everybody in a society. They are important not only in business
and politics but in every human endeavour.
- There exist no sharp boundaries between ethical and non-ethical.
Therefore, people often face ethical dilemmas wherein a clear cut choice
CHECK YOUR becomes very difficult.
PROGRESS - The concepts of equity and justice are implicit in ethics. Fair and equitable
treatment to all is its primary aim.
Describe Features of - Ethics and legality of action do not necessarily coincide. What a society
Ethics? interprets as ethical or unethical ends up expressed in laws. The legality
of actions and decisions does not necessarily make them ethical. For
example, not helping an injured person in a road accident may be unethical
but not illegal.

Business ethics
The study of moral values based on economic systems prevalent in different
countries and across the globe is called as "Business Ethics". In today's changing
environment this can also be recognized as corporate ethics.
" Business ethics refers to the moral principles and standards and a code
of conduct that businessmen are expected to follow while dealing with others."

11.6 Ethical Theories and Approach

There are three categories of Ethical theories:-
1. Teleological Ethical Theory
2. Deontological Ethical Theory
3. High breed Theory (combination of 1 and 2)

1. Teleological Ethical Theory:-

This theory deals with an ethical decision by measuring the probable result
or consequences. This theory is utilitarian which searches at it ends the greatest
'good' (or utility) for the greatest number, the system is analysed by application of
cost benefit analysis i.e. to tally the costs vis-à-vis benefits (utilization) for the
given decision. After analysis the best and most effective decision is finalized which
also provides maximum, overall gain?
This system is easy to apply but has several complex problems. It is difficult
to measure exact benefit. Utilitarianism is a strong theory and simple and flexible
and liberal; easier to describe human decision making process. Its weakness is
Banking Laws and possible result of injustice in relation to distribution of goods. No one has greater
(158) Operations - I
weightage than other and its effect is that an individual may suffer greater loss or Ethics and Corporate
harm compared to others who gain. Governance in Banking
Distributive Justice- According to philosopher John Rawls (Harvard)
distributive justice terms that ethical decisions are to distribute goods and services
and as such it is too difficult to find out exact method to distribute goods and NOTES
services and service with sense of equity.
For equitable distribution of good and service, Rawls is of the view to built
cooperative system in which benefits shall be distributed unequally only if it benefits
all. He points out that ethical justice can be made by Capacity of Decision (we act
upon) to enhance cooperation between the members of the (cooperative) society.
Here, even if you are ignorant, you will take a just decision under framework.
Example:-
When Bhakhra Nangal dam was created, a decision to acquire land for
creating dam, canal and roads did create a harm (loss) to a few farmers whose
land was taken over but due to this project a fewer were harmed where as the
entire state of Punjab turned in to a most economically strong groups and here is
CHECK YOUR
how evil to a few created economical and social good to several.
PROGRESS
In a crime when a few dacoits are killed in encounter it provides peace to
thousands and lacs of people in the area by arresting crime. There are several Describe Ethical
such examples daily happening around you. Theories and
Approach?
2. Deontological Ethical theory:
According to Deontological theories, though the consequences of an act
are good, some acts are always wrong. In deontological theories actions are judged
as ethical or unethical based on duty or intentions of an actor. The most important
defender of deontological ethics is Immanuel Kant who forwards his moral theory
in 1788.
Kant's ethical theory includes duty without regard to human happiness.
His moral theory is based on his view of the human being as having the unique
capacity for rationality. No other animal possesses such a propensity for reasoned
thought and action, and it is exactly this ability which obliges us to act according to
the moral law / duty.
Kant's moral theory emphasises acting in accordance with and for the
sake of duty. Kant believed that inclinations, emotions and consequences should
play no role in moral action. This means that motivation for action must be based
on obligation. Morality should provide us with a framework of rational principles
(rules) that guide and restrict action, independent of personal intentions and desires.
It is worth mentioning that another divergence between the theories of
utility and deontology is the way in which they are constructed: utilitarianism is
concerned with actively maximising the good while deontology is more negatively
focused on avoiding the morally impermissible (or on the constraints of action).
The moral worth of an action is determined by the will. The human will is
the only thing in the world that can be considered good without qualification, according
to Kant. Good will is exercised by acting according to moral duty/law. The moral
consists of a set of moral maxims which are categorical in nature.
According to Kant, every action has a maxim. Maxim means rule of
principle. He tries to provide a universal law that is true under any circumstances
for everyone. It can be concluded that deontological ethics based on
Kantian ethics emphasizes a universal morality. The principle of
deontological ethics can be summed up in the phrase, "treat others as you would be
treated". Banking Laws and
Operations - I (159)
Banking Laws and Kant distinguishes two kinds of imperatives; hypothetical and categorical
Operations - I imperatives. Hypothetical imperatives are conditional, whereas categorical
imperatives are unconditional and they must be obeyed under any conditions.
Hence, according to Kantian ethics is an action passes the test of categorical
NOTES imperative, the action is ethical. It can be claimed that categorical imperative rules
out some certain practices, such as theft, fraud, coercion and so on in business left.
If Kantian ethics can be applied in business life, it provides universal place in
business world.

3. Hybrid Theories:
It is a mix of both the theories described above. It is a means for decision
making i.e. take a decision you like or do what you want. While making a decision
identify the greatest good and the greatest good is that which is greatest good
realized by the decision maker and is hybrid. This theory will be clear from the
story " A King asked for hot water in a glass tumbler, the glass cracked, again he
asked for a very cold water in another glass tumbler. It again cracked. To solve the
problem he asked Birbal (one of his nine Ratnas) to solve the problem- Birbal
served hot water mixed with cold in the tumbler, it did not crack" and was awarded
for this act. This is how Hybrid Theory works.
How to deal with decisions taken at top level- The fundamental is that the
top level officials in government departments and managers and CEOs of corporate
daily take a decision that forms a shape of ethical or unethical results. The golden
rule is "An evil to a few and gain or advantages to several is the golden principle of
decision making", here a mention can be made of one of the decisions by Chief
Minister of Punjab- Pratap Sing Karon to built Bhakhara Nangal Dam and Canals
resulted in to loss to a few villagers by accommodating the project but today more
than 99% villages are enjoying the benefits of it. Due to this project the economic
face of the then Punjab, now Punjab and Haryana changed and Punjab is fulfiling
by its agriculture revolution a majority of food need of India.

11.7 Ethics: Certain important concepts:

Ethics involves a discipline that examines good or bad practices within the
context of a moral duty. Moral conduct is the behavior that indicates which is right
and wrong. Business ethics include practices and behaviors that are good or bad,
in other words ethical or unethical.
There are many concepts of ethics and some of them are discussed below:
(1) Utilitarianism: Action is morally right. If, the total net benefit of the
action exceeds the total net benefit of any other action. In other words, the result
of the action is more favorable than unfavorable to everyone.
(2) Egoism: The theory which treats self-interest as the base of morality.
Two forms of ethical egoism can be identified as individual and universal, which
include other's interest only from the point of the assessors' self interest. It is
mainly self-centered, and importance is given to self pleasure and gain and avoids
pressure and pain.
(3) Rights: A Right is considered as a person's just claim or entitlement.
1. Legal rights : defined by a system of laws
2. Moral rights : based on ethical standard - principles of right or wrong
3. Justice : Justice is the decision which could arise from the application of
rules, policies, or laws that apply to a society or a group
Banking Laws and
(160) Operations - I
 Ethics and Corporate
11.8 Corporate governance ethics Governance in Banking

Business ethics and corporate governance of an organization go hand in

hand. In fact, an organization that follows ethical practices in all its activities will, in
NOTES
all probability, follow best corporate governance practices as well.
Corporate governance is meant to run companies ethically in a manner
such that all stakeholders including creditors, distributors, customers, employees,
the society at large, governments and even competitors are dealt with in a fair
manner. Good corporate governance should look at all stakeholders and not just
the shareholders alone. Corporate governance is not something which regulators
have to impose on a management, it should come from within.
A business organization has to compete for a share in the global market on
its own internal strength, in particular on the strength of its human resource, and on
the goodwill of its other stakeholders. While its State-of-the-art technologies and
high level managerial competencies could be of help in meeting the quality, cost,
volume, speed and breakeven requirements of the highly competitive global market,
it is the value-based management and ethics that the organization has to use in its
governance. This would enable the organization to establish productive relationship CHECK YOUR
with its internal customers and lasting business relationship with its external PROGRESS
customers.
Describe Corporate
governance ethics?
11.9 Scope of Business Ethics
Ethical problems and phenomena arise across all the functional areas of
companies and at all levels within the company which are discussed below:

11.9.1 Ethics in Compliance

Compliance is about obeying and adhering to rules and authority. The
motivation for being compliant could be to do the right thing out of the fear of being
caught rather than a desire to abide by the law. An ethical climate in an organisation
ensures that compliance with law is fuelled by a desire to abide by the laws.
Organisations that value high ethical values comply with the laws not only in letter
but go beyond what is stipulated or expected of them.

11.9.2 Ethical aspects in Human Resource Management

(i) Transparency: Transparency is one of the important ethical aspects in
HRM. Lack of openness in interpretation, decision making and communication,
performance appraisal, promotion process etc would de-motivate the employees.
(ii) Internal Stakeholders : Employees are important internal stakeholders
and need to be dealt with highly ethical practices for all-round progress of the
institution.

11.9.3 Ethichal aspects in Marketing Management

Marketing Mix is an important factor that determines the performance of
the marketing team. There are "4 Ps" of Marketing Mix viz., Place, Product, Price
and Promotion. The unethical issues concerning these "4Ps" are:
Place:
"Place" is the link between the customer and producer, through appropriate Banking Laws and
delivery channels. Convenient location plays a crucial role in increasing the sale of Operations - I (161)
Banking Laws and the products. As regards banking, the term "place" represents their delivery channel
Operations - I i.e., branch net work, e banking channels like ATMs, Internet, Core Banking
Solutions, etc. For the convenience of customers ATMs are also available at off
site locations. The place acts as an important factor of the marketing mix, and
NOTES ensures good customer relationship management. Unethical practices on account
of "Place" as part of marketing mix arises in the following situations: (a) If a branch
of a bank is relocated to another area without sufficient notice and time (b) A
customer who uses ATMs, Internet banking facility, is denied access to them on
account of bank's failure to provide the services, and thereby the customer is
facing inconvenience, loss of money and time.
Product:
"Product" is one of the important components of marketing mix. Product
can be in the form of goods or an article or an instrument (in case of financial
services), for which the consumer pays a value (price) and expects to get satisfaction/
comfort.
If a bank offers a deposit product offering higher interest and suddenly
stops offering such type of deposit products without any prior notice, then from the
customers' point of view this could be viewed as unethical practice. Similarly when
new loan products with certain value added features are launched, such value
additions are offered only for the new loan customers but not for existing loan
customers could be viewed as unethical by the existing customers.
Price:
"Price" is another important component of a marketing mix.
Price discrimination is labeled as unethical. For example, A bank, when
there is change in the floating interest rates, immediately increases the interest
rates for loan accounts for the existing borrowers, however, in case of rate cut, the
bank does not reduce the interest rate immediately, is considered as unethical.
Another example of unethical practice is, any increase in charges, fees are given
immediate effect, however any reduction in charges, fees, etc which would benefit
the customers, is not passed on to them immediately.
Promotion:
Reaching out to the customers through effective network and attractive
communication is the major role of the marketing mix called "promotion".
Advertisement is the main component of promoting products. Unethical
practices are:
(i) misleading advertisements to attract the clients
(ii) unsolicited telephone calls, e mails, and thereby inconveniencing the clients.
11.9.4 Ethical aspect in Financial Management
A sound financial policy and effective management control, is very important
for good corporate governance. Many unethical practices noticed in the area of
financial management are putting pressures on the regulators and governments
which affect both internal and external stakeholders.
Some of the noteworthy unethical issues in the financial activities and
markets are:
1. Concealment of facts:
In case of Satyam's scam, for years the (real) financial position was
concealed but unrealistic financial position was reflected in a systematic manner to
appear as realistic numbers.
2. Money Laundering activities:
Banking Laws and This is not only unethical but also criminal and illegal. These activities
(162) Operations - I
include conversion of illegal money into legal money, using the banks as channels Ethics and Corporate
to effect such activities. Governance in Banking
3. Misappropriation and diversion of funds:
Many business enterprises including corporate avail loans and do not use
the funds for the purpose the loan was availed of, but divert the funds for other NOTES
activities. For example: A manufacturing company avails of working capital finance
for production purpose. The funds are raised against hypothecation of goods;
however the funds are not used for production of the goods, but invested in real
estate sector and/or capital markets to earn higher returns.
Though the repayment of the loan is on schedule, these activities of the
company are unethical on account of misappropriation of funds
4. Lack of internal control:
Due to weak internal controls at appropriate levels, sometimes loans become
nonperforming assets. Unethical practices like corruption, diversion and
misappropriation of funds, loans granted against collateral which are of inferior
quality, lesser value, etc., not only affect the performance of the banks but also
increases the levels of nonperforming assets.
5. Non compliance of regulatory and legal frame work: CHECK YOUR
Banks face many compliance issues, by not following the rules and PROGRESS
regulations.. These non compliances have created avenues for conversion of black
money to legal money through banking channels, and made banks not only to face Describe Desired
embarrassment but also reputational risks. Ethical Practices and
C o r p o r a t e
Governance?
11.10 Desired Ethical Practices and Corporate
Governance
Some important factors of ethical issues as listed below, if not handled
properly, would affect the corporate governance practices.
(1) Conflict of interest:
In case of mergers and acquisitions, (M&As), an audit firm offers
consultancy services through their consultancy division. The expertise of auditors'
of the audit division, might be used by the consultancy division in valuations and this
may be considered as an example of conflict of interest
(2) Transparency:
In financial statements and annual reports, "disclosures of actual facts to
stakeholders" helps the investors and others to take decisions. Non transparent
practice is window dressing of data and figures in the financial statements.
(3) Insider Trading:
The growth of the global economies depends (among other factors) upon
the successful participation of financial and other competitive markets. Any changes
in prices (interest rates, exchange rates and prices of commodities) significantly
affect the profitability of the companies; thereby affect the economic growth of a
nation. There are many ways price of a product, and/or interest rate of an investment
instrument, and/or exchange rate of a foreign exchange transaction can change or
move upwards and/or downwards. Any person, who by virtue of his position in a
corporate, can have access to sensitive information relating to the price. If such
person makes use of this information to his advantage, which is unethical, it is
called as insider trading.
(4) Mergers & Acquisitions (M&As):
Banking Laws and
In the competitive international business environment, mergers and Operations - I (163)
Banking Laws and acquisitions play a crucial role in business expansion across borders. Management
Operations - I Buyout is one type of takeover. In this case, the management decides to bid for the
company. If successful, they can convert the company to a private company and
at a later date depending upon the market conditions sell it in the market and make
NOTES good profits. Unethical aspects relating to such take over, may be that during the
buyout confidential information is leaked by employees/managers for their benefit
and there will be a possibility of bringing down the share prices by the vested
parties for buying them at a very cheaper rate.
(a) Golden parachute:
Special incentives and benefits are offered to top executives to avoid a
takeover situation. These benefits would include bonuses, stock options, etc., In
view of the golden parachute; the top executives might not support the takeover of
the company
(b) Hostile Takeovers:
When there is opposition from the board or employees or officers of the
target company not to allow mergers and acquisitions, it is called as hostile takeovers.
On account of vested interests, and to protect their own interests, managers may
oppose the M & A.
(c) Green mail:
It is a process through which the management of the target company
sends green mails to prevent a shareholder or group of share holders to take over
a company. There is a possibility of the buy back of the shares at a premium by the
company at a later stage. Hence green mails are considered unethical.
In short, mergers and takeovers are considered unethical, if they ignore
the interests of the shareholders.

11.11 Key Concepts

The word "ethics" is derived from the Greek word "ethikos" which means
character or custom.
Business ethics refers to the moral principles and standards and a code of
conduct that businessmen are expected to follow while dealing with others.
Corporate governance is meant to run companies ethically in a manner
such that all stakeholders including creditors, distributors, customers, employees,
the society at large, governments and even competitors are dealt with in a fair
manner.

11.12 Summary
l Business ethics, Corporate Governance and Corporate Social Responsibility
have become not only a integral part of the present globalised business
environment, but also have changed the business models of Banks.
l With stiff competition among themselves, to retain market share and also to
ensure the Bank's reputation, banks' strategies are tuned to the need of the
hour.
l Corporate governance is meant to run companies ethically in a manner such
that all stakeholders including creditors, distributors, customers, employees,
the society at large, governments and even competitors are dealt with in a
fair manner.
l More and more Banks have started to reshape themselves to offer better
customer services and also operate in more ethical manner, through their
Banking Laws and
(164) Operations - I
effective corporate governance practices.
 Ethics and Corporate
11.13 Exercise Governance in Banking

Fill in the blanks

1. Ethics is a conception of ________or wrong conduct. NOTES
(Necessary, Important, Right)
2. The concepts of equity and justice are implicit in ethics. ______________
treatment to all is its primary aim.
(Fair & Equitable, bias & unequal, good & equitable)
3. _____________ theory deals with an ethical decision by measuring the
probable result or consequences.
(teleological, deontological, egoism)
4. In ___________ theories actions are judged as ethical or unethical based
on duty or intentions of an actor.
(teleological, deontological, egoism)
5. A mix of deontological and teleological theories is called as
__________theory.
(Virtue Ethics, Egoism, Hybrid)
6. The theory which treats self-interest as the base of morality is called as
__________.
(Egoism, Virtue ethics, Teleology)
7. ___________is about obeying and adhering to rules and authority.
(Following, Regulating, Compliance)
8. Transparency, stakeholders' rights, gender equality are the aspects of ethics
in _________.
(Financial management, Human Resource Management, Marketing
Management)
9. __________ issues like insider trading, conflict of interest, if not handled
properly, would affect the corporate governance of an organization.
(Internal, Technical, Ethical)
10. Concealment of facts, money laundering, and misappropriation of funds are
the unethical issues in the ______________.
(Financial management, Human Resource Management, Marketing
Management)
[ANS: 1)Right 2)Fair & Equitable 3)Teleological 4)Deontological 5)Hybrid
6)Egoism 7)Compliance 8)Human Resource Management 9)Ethical
10)Financial Management ]

11.14 Further Readings & References

1. M.L.Tannan, revised by : Banking Law and Practice, Wadhwa & Company,
Nagpur C.R. Datta & S.K. Kataria
2. A.B. Srivastava and : Seth's Banking Law, Law Publisher's India (P) Limited
K. Elumalai
3. R.K. Gupta : BANKING Law and Practice in 3 Vols. Modern Law Publications.
4. Prof. Clifford Gomez : Banking and Finance - Theory, Law and Practice, PHI
Learning Private Limited
5. J.M. Holden : The Law and Practice of Banking, Universal Law Publishing. Banking Laws and
Operations - I (165)
Banking Laws and
Operations - I UNIT 12
CORPORATE GOVERNANCE IN BANKS
NOTES Structure
12.0 Introduction
12.1 Objectives
12.2 Classification of Banks
12.3 Regulation of Banks
12.4 Board Composition
12.5 Role of the Board of Directors
12.6 Audit Committee (AC)
12.7 Induction of More Independent Directors
12.8 Auditors and other Internal Audit Reports
12.9 Customer Service Committee
12.10 Special Committee for monitoring large value frauds
12.11 IT Strategy Committee
12.12 Remuneration Committee
12.13 Nomination Committee
12.14 BASEL Committee Recommendations
12.15 Auditors' Certificate on Corporate Governance
12.16 Corporate Social responsibility in the financial Sector
12.17 Key Concepts
12.18 Summary
12.19 Exercise
12.20 Further Readings & References

12.0 Introduction
The economic development of a country in the modern age can be judged
from the efficiency of its banking system. They are central to market development
and socio-economic growth, regulatory and economic reforms.
Banks have an especially important role in any economy. First and foremost,
they accept deposits from the general public and also are liable to them. As these
deposits constitute a significant portion of a nation's wealth, they must be managed
appropriately.
Banks are different from other corporates in many important respects,
and that makes corporate governance of banks not only different but also more
critical. By the very nature of their business, banks are highly leveraged. They
accept large amounts of public funds as deposits in a fiduciary capacity and further
leverage those funds through credit creation. The presence of a large and dispersed
base of depositors in the stakeholders group sets banks apart from other corporates.
If a corporate fails, the fallout can be restricted to the stakeholders. If a bank fails,
the impact can spread rapidly through to other banks with potentially serious
consequences for the entire financial system and the macro economy.
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 Corporate Governance
12.1 Objectives in Banks

After reading this unit, you should be able to:

Understand the Bank sector specific governance structure & Study the
NOTES
Corporate governance norms (other than the Listing Agreement) applicable to
Public sector and private sector banks.

12.2 Classification of Banks

In the Indian context, banks can be classified as Scheduled Bank and
Unscheduled Bank. Scheduled Banks expressed as Scheduled Commercial Banks
(SCBs) which can be further grouped as State Banks Group and other Nationalized
Banks, Foreign Banks, Regional Rural Banks and other Scheduled Commercial
Banks.
Once the name of a bank is included in the Second Schedule to the Reserve
Bank of India Act, 1934, it is called a Scheduled Bank. A Scheduled Bank is entitled CHECK YOUR
to facilities of refinance from RBI, subject to fulfillment of the following conditions PROGRESS
laid down in Section 42 (6) of the Act, as follows:
- it must have paid-up capital and reserves of an aggregate value of not Describe
less than an amount specified from time to time; and Classification of
- it must satisfy RBI that its affairs are not being conducted in a manner Banks?
detrimental to the interests of its depositors.
For the purpose of assessment of performance of banks, the Reserve
Bank of India categories them as public sector banks, old private sector banks,
new private sector banks and foreign banks.
In 1969, the Government of India issued an Ordinance (Banking Companies
(Acquisition and Transfer of Undertakings) Ordinance, 1969, and 14 scheduled
commercial banks were nationalised in order to expand the branch network, followed
by six more in 1980. A merger reduced the number from 20 to 19. The State Bank
of India was nationalized in 1955 under the SBI Act of 1955.
Nationalized banks are wholly owned by the Government, although some
of them have made public issues. Nationalized banks are not registered under the
Companies Act, 2013 and therefore the Companies Act does not apply to them.

12.3 Regulation of Banks

The Reserve Bank of India, the central bank of the country, is the primary
regulator of banks. The Banking Regulation Act, 1949 applies to all banks. The
provisions of this Act shall be in addition to, and not, unless expressly provided, in
derogation of the Companies Act, 2013 and any other law for the time being in
force. Companies Act, 2013 is applicable to all private sector banks registered
under the Companies Act, 2013.
Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970
and 1980 is applicable to all nationalized banks except State Bank of India, which
is governed by the State Bank of India Act.
Additionally all listed banks are required to comply with the listing agreement
except where the provisions are not in conformity with directives of Reserve Bank
of India or the Act as applicable to a respective bank.
In this study lesson we will study the Corporate governance norms (other
than the Listing Agreement) applicable to Public sector and private sector banks. Banking Laws and
Operations - I (167)
Banking Laws and
Operations - I 12.4 Board Composition
In terms of Banking Companies (Acquisition and Transfer of Undertakings)
Act, 1970, which is applicable to nationalised banks, the Board Composition shall
NOTES
include-
(a) not more than two whole-time Directors to be appointed by the Central
Government after consultation with the Reserve Bank;
(b) one Director who is an official of the Central Government to be nominated
by the Central Government.
Such Director shall not be a Director of any other nationalized bank.
(c) one Director who is an officer of the Reserve Bank to be nominated by
the Central Government on the recommendation of the Reserve Bank.
(d) not more than two Directors to be nominated by the Central Government
from amongst the Securities Exchange Board of India established under
Section 3 of the Securities and Exchange Board of India Act, 1992 (15
CHECK YOUR
of 1992), the National Bank for Agriculture and Rural Development
PROGRESS
established under Section 3 of the National Bank for Agriculture and
Rural Development Act, 1981 (16 of 1981),public financial institutions
Describe Board as specified in sub-section (1), or notified from time to time under sub-
Composition? section (2), of Section 2(72) of the Companies Act, 2013 and other
institutions established or constituted by or under any Central Act or
incorporated under the Companies Act, 2013 and having not less than
fifty-one per cent of the paid-up capital held or controlled by the Central
Government;
(e) one Director, from among such of the employees who are workmen
under clause (s) of Section 2 of the Industrial Disputes Act,1947 (14 of
1947), to be nominated by the Central Government in such manner as
may be specified in a scheme made under this section;
(f) one Director, from among the employees who are not workmen to be
nominated by the Central Government after consultation with the Reserve
Bank;
(g) one Director who has been a Chartered Accountant for not less than
fifteen years to be nominated by the Central Government after
consultation with the Reserve Bank;
(h) subject to the provisions of clause
(i) not more than six Directors to be nominated by the Central Government;
Where the capital issued under clause (c) of sub-section (2B) of Section
3 is-
(i) not more than twenty per cent of the total paid-up capital, not more
than two Directors,
(ii) more than twenty per cent but not more than forty per cent of the
total paid-up capital, not more than four Directors,
(iii) more than forty per cent of the total paid-up capital, not more than
six Directors, to be elected by the shareholders, other than the Central
Government, from amongst themselves:
On the assumption of charge after election of any such Directors under
this clause, equal number of Directors nominated under clause (h) shall retire in
such manner as may be specified in the scheme.
The Directors to be nominated under clause (h) or to be elected under
Banking Laws and clause (i) of sub-section; (3A) shall,-
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(A) have special knowledge or practical experience in respect of one or Corporate Governance
more of the following matters namely,- in Banks
(i) agricultural and rural economy,
(ii) banking,
NOTES
(iii) co-operation,
(iv) economics,
(v) finance,
(vi) law,
(vii) small scale industry,
(viii) any other matter the special knowledge of and practical experience in,
which would in the opinion of the Reserve Bank, be useful to the
corresponding new bank;
(B) represent the interests of depositors; or
(C) represent the interest of farmers, workers and artisans.
In other words, in a nationalised bank, In addition to the Chairman and CHECK YOUR
Managing Director and Executive Director(s), the Board should comprise the PROGRESS
following Non Executive Directors:
1. Nominee of GOI - (Official of the Central Government); Describe Role of the
2. Nominee of RBI - (Official of Reserve Bank of India); Board of Directors?
3. Workmen Director - Representing the interest of Workmen of the Bank;
4. Non Workmen Director - Representing the interest of Officer of the
Bank;
5. A Chartered Accountant with minimum 15 years experience-nominated
by Government of India;
6. Not more than six directors - Nominated by Government of India -
representing various areas of interest such as Finance, Economics,
Banking, Artisan, Agriculture etc., or any other area considered useful
to the bank by RBI.
7. Two, four or six Directors elected by Shareholders other than Central
Government based on dilution of Government of India's shareholding in
the Bank

12.5 Role of the Board of Directors

(i) The Bank's Board of Directors should meet regularly and to provide
effective leadership and insights in business and functional areas. They
also should monitor Bank's performance.
(ii) Setting up of a framework of strategic control and continuously reviewing
its efficacy.
(iii) Implementation, review and monitoring the integrity of its business and
control mechanisms
(iv) Overseeing the risk profile of the Bank.
(v) Ensuring expert management and decision-making, internal control and
reporting requirements.
(vi) Maximizing the interests of its stakeholders.

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Operations - I (169)
Banking Laws and
Operations - I 12.6 Audit Committee (AC)
The Audit committee functions as per RBI guidelines and complies with
the provisions of Clause 49 of the Listing Agreement to the extent that they do not
NOTES
violate the directives/guidelines issued by RBI. Functions of Audit Committee:
(a) Audit Committee provides direction and also oversees the operation of
the total audit function in the Bank.
(b) Audit Committee also appoints Statutory Auditors of the Bank and
reviews their performance from time to time.
(c) Ensures transparency by reviewing bank's financials, Risk Management,
IS Audit Policies and Accounting policies, systems and procedures.
(d) Audit Committee also reviews the internal inspection/audit plan and
functions in the Bank - the system, its quality and effectiveness in terms
of follow-up.
(e) Audit Committee focuses on the follow up of implementation:
CHECK YOUR - KYC-AML Guidelines;
PROGRESS - Major areas of housekeeping;
- Compliance of Clause 49 and other guidelines issued by SEBI from
What is AC? time to time;
(f) Audit Committee follows up on all the issues raised in RBI's Annual
Financial Inspection Reports under Section 35 of Banking Regulation
Act, 1949 and Long Form Audit Reports of the Statutory

12.7 Induction of More Independent Directors

Induction of more Independent Directors who have no business connection
with bank and are dedicated to work. They should be specialists in different functions
such that their contribution helps in enriching the quality of governance and
avoidance of unethical practices.
Majority of the frauds are due to unethical practices and in case governance
was good these could have been avoided or minimized.
Example:- the case of Satyam Computer, King Fisher Airlines and Sahara
India are the burning cases. The worst was Dabhol Power Plant, Mumbai.
The recent emphasis of including women directors is another approach
for empowerment; here women are expected to take more ethical decisions.

12.8 Auditors and other Internal Audit Reports

The meetings of Audit Committee are chaired by a Non-Executive Director.
The constitution and quorum requirements, as per RBI guidelines, are to be complied
with
Apart from Audit Committee other committees also assist the Board of
Directors.
Shareholders'/Investors' Grievance Committee: As per Clause 49 of the
Listing Agreement with the Stock Exchange, Shareholders'/ Investors' Grievance
Committee of the Board looks into the redressal of shareholders' and investors'
complaints regarding transfer of shares, non-receipt of annual report, non-receipt
of interest on bonds/declared dividends, etc
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 Corporate Governance
12.9 Customer Service Committee in Banks

The Customer Service Committee reviews ongoing improvements on a

continuous basis in the quality of customer service provided by the Bank.
NOTES

12.10 Special Committee for monitoring large value

frauds
This committee's functions are:
- to monitor and review all large value frauds with a view to identify
systemic issues/risk, if any,
- to find out the reasons for delay in detection and reporting, if any
- to follow up on the status of progress of CBI/Police investigation,
recovery position, etc.
- Action if any on staff involvement and their accountability and action
thereof CHECK YOUR
- Also review the preventive measures to avoid similar frauds PROGRESS

What is IT Strategy
12.11 IT Strategy Committee Committee?

This committee assists the Board to track the progress of the Bank's IT
initiatives. Some of the important functions of the committee are
(a) approving IT strategy and policy documents, ensuring that the
management has put an effective strategic planning process in place;
(b) ensuring that the IT operational structure complements the business
model and its direction;
(c) ensuring IT investments represent a balance of risks and benefits and
those budgets are acceptable;
(d) evaluating effectiveness of management's monitoring of IT risks and
overseeing the aggregate funding of IT at the Bank level; and
(e) reviewing IT performance matches with the bank's policy/plans

12.12 Remuneration Committee

This is one of the important committee in organization. This committee is
set up for evaluating the performance of Whole Time Directors of the Bank in
connection with the payment of incentives, as per the scheme advised by
Government of India. The remuneration of the whole-time Directors and the Sitting
Fees paid to the Non-Executive Directors for attending the meetings of the Board/
Committees of the Board are as prescribed by GOI from time to time.

12.13 Nomination Committee

As per RBI guidelines, a Nomination Committee of independent Directors
has been constituted.
This committee's function is to carry out necessary due diligence and arrive Banking Laws and
Operations - I (171)
Banking Laws and at the 'fit and proper' status of candidates filing nominations for election as Directors
Operations - I by shareholders.
Every financial year the Directors on the Bank's Board and Senior
Management have to sign a declaration for compliance with the Bank's Code of
NOTES Conduct for the financial year.

12.14 BASEL Committee Recommendations

The Basel Committee guidance provides a foundation for sound corporate
governance practices for various banking system across countries. The guidance
is divided into four major sections (i) overview of corporate governance in banks
(ii) sound corporate governance principles (iii) role of supervisors and (iv) promotion
of an environment to support sound corporate governance.
(i) Overview of Corporate Governance in Banks: The guidance stressed
the importance of sound corporate governance practices as vital in gaining
CHECK YOUR and maintaining public trust and confidence in the banking system and
PROGRESS economy as a whole. The guidance suggested that the supervisors should
take steps to ensure that the ownership structure does not affect the
What is BASEL? sound corporate governance practices in banks.
(ii) Sound corporate governance principles: The committee proposed eight
principles which are considered important for an effective corporate
governance process.
Principle 1: Board members should be qualified for their role in corporate
governance and be able to exercise sound judgment in handling the affairs
of the bank
Principle 2: The board of directors should approve and oversee the bank's
strategic objective and corporate values that are communicated
throughout the organization
Principle 3: The board of directors should set and enforce clear lines of
responsibility and accountability throughout the organization
Principle 4: The board should ensure that there is appropriate oversight
by senior management consistent with board's policy
Principle 5: The board and senior management should effectively utilize
the work conducted by the internal auditors, external auditors and internal
control systems
Principle 6: The board should ensure that compensation policies and
practices are in consistent with the bank's corporate culture, long tern
objectives and strategy
Principle 7: The bank should be covered in a transparent manner
Principle 8: The board and senior management should understand the
bank's operational structure and the jurisdiction
(iii) The Role of Supervisors: Supervisors play a key role to encourage and
support strong corporate governance by analyzing and assessing a bank's
implementation skills of the sound principles. Supervisors should
- Provide guidance to banks on sound corporate governance
- Consider corporate governance as one factor for depositor protection
Banking Laws and - Assess the quality of banks' audit and control systems
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 - Evaluate the bank's performance in respect of effective implementation Corporate Governance
of corporate governance in Banks

(iv) Promotion of an environment to support sound corporate governance:

As per the report the primary responsibility for good governance rests
with board of directors and senior management of banks. Banks NOTES
supervisors also play a key role in developing and assessing bank
corporate governance practices. The guidance report also lists out role
of others who can promote good corporate governance like shareholders,
customers, depositors, auditors, Banking Industry associations,
Governments, Credit rating agencies, Employees, stock exchanges etc;
According to the Basel guidance banks' good corporate governance
practices would entail banks for better operational efficiency, greater opportunities
to get low cost funds, and a good reputation and increased market value.

12.15 Auditors' Certificate on Corporate Governance

This certificate issued by Chartered Accountant, is to be furnished along CHECK YOUR
with the Annual Report of the Bank. The certificate indicates the examination by PROGRESS
the chartered accountant regarding compliance of conditions of Corporate
Governance by the Bank for the financial year ending. This certificate is based on Describe Corporate
the clause 49 of the listing agreement of the bank with Stock Exchanges in India. Social responsibility in
The compliance of the conditions of Corporate Governance is the responsibility of the financial Sector?
the Management. The auditor's examination is being carried out in accordance
with the Guidance Note on Certification of Corporate Governance, issued by the
Institute of Chartered Accountants of India.
It is regarding the compliance of corporate governance procedures and
implementation thereof, adopted by the bank.

12.16 Corporate Social responsibility in the financial

Sector
The institutions representing the financial sector like banks, mutual funds
and other institutions. like other corporate sector players contribute significantly to
the community development in many ways. International Financial Corporation
(IFC) an affiliate of the World Bank, International Chamber of Commerce (ICC)
and United Nations Organization (UNO) are participating in the various projects
across the world. They are motivating banks and financial institutions to play an
effective role in promoting environmental protection and social sustainability through
these projects. In this respect, the financial institutions and banks are encouraged
to follow certain principles in respect of CSR
(a) Commitment to sustainability: FIs should expand their mission of profit
maximization to a vision of social and environmental sustainability. To
achieve this FIs should integrate the consideration of ecological limits,
social equity and economic justice into their corporate strategies and
into their core business models.
(b) Commitment to 'Do No Harm': FIs should prevent or minimize harm to
the environment
(c) Commitment to Responsibility: FIs should take full responsibility for the
environmental and social impacts of their transaction
Banking Laws and
(d) Commitment to Transparency: FIs should have transparency in their
Operations - I (173)
Banking Laws and policies and business dealings
Operations - I
(e) Commitment to Accountability: FIs should be accountable to their
stakeholders and the community where they operate. FIs should promote
economic development through their CSR activities
NOTES (f) Commitment to good governance: FIs should frame good corporate
governance policies and follow them in letter and spirit.
Quite often we come across many news pertaining to the CSR activities
of banks and other players in the financial sector.

Some examples of CSR activities are:

Environment protection: Going Green is an eco friendly initiative not only
to protect the environment but also to encourage younger generation to ensure
such initiatives would lead to a better life around us. Some of the green initiatives
include eco friendly e communication, banks and companies forwarding the annual
reports by electronic mode (saving reams of papers for printing reports to the
shareholders) Saving the globe from different kinds of pollution such as water, air,
noise. etc.
Health Care: Many banks and other financial institutions including
government organizations are keen in ensuring better health care facilities are
provided for the needy persons. They organize regular blood donation drives, free
medical checkups, donating ambulances, sponsoring free medical camps in remote
villages.
Education: Educational services occupy an important position in CSR
activities of organizations. Many organizations are promoting community schools,
colleges. Scholarships are offered to many deserving students.
Social Causes: Many banks offer help and financial assistance through
their CSR programs to assist weak sections of the society for a better future.
Apart from the above many employees of the banks and other institutions,
are very active in their contribution for the community development and these can
very well be considered as part of Corporate Social Responsibility in view of the
fact that each person is a stakeholder in one respect or another.

12.17 Key concepts

Scheduled Banks expressed as Scheduled Commercial Banks (SCBs)
which can be further grouped as State Banks Group and other Nationalized Banks,
Foreign Banks, Regional Rural Banks and other Scheduled Commercial Banks.
The Audit committee functions as per RBI guidelines and complies with
the provisions of Clause 49 of the Listing Agreement to the extent that they do not
violate the directives/guidelines issued by RBI.

12.18 Summary
- Business ethics, Corporate Governance and Corporate Social
Responsibility have become not only an integral part of the present
globalised business environment, but also have changed the business
models of Banks.

- With stiff competition among themselves, to retain market share and

Banking Laws and
also to ensure the Bank's reputation, banks' strategies are tuned to the
(174) Operations - I
 need of the hour. Corporate Governance
in Banks

- More and more Banks have started to reshape themselves to offer

better customer services and also operate in more ethical manner, through
their effective corporate governance practices. NOTES

12.19 Exercise
Fill in the blanks
1. In case of nationalised banks, the Board Composition shall include not more
than ______ whole-time Directors to be appointed by the Central Government
after consultation with the Reserve Bank.
(three, two, one)
2. The Bank's __________ should meet regularly and to provide effective
leadership and insights in business and functional areas. They also should
monitor Bank's performance.
(shareholders, customers, board of directors)
3. Maximizing the interests of its stakeholders is one of the roles of the
_____________-.
(shareholders, customers, board of directors)
4. ____________ Committee provides direction and also oversees the operation
of the total audit function in the Bank.
(Audit, Nomination, Remuneration)
5. The meetings of Audit Committee are chaired by a ____________ Director.
(independent, non-executive, whole time)
6. The __________- Committee reviews ongoing improvements on a continuous
basis in the quality of customer service provided by the Bank.
(Audit, nomination, customer service)
7. _____________ committee is set up for evaluating the performance of
Whole Time Directors of the Bank in connection with the payment of
incentives, as per the scheme advised by Government of India.
(Audit, Nomination, Remuneration)
8. As per RBI guidelines, a Nomination Committee of _________ Directors
has been constituted.
(Executive, non-executive, independent)
9. Commitment to sustainability, 'Do No Harm', Responsibility, Transparency,
Accountability, good governance, are some of the principles of __________
(CSR, CG, RBI)
10. Ensuring that the IT operational structure complements the business model
and its direction is the function of ___________ Committee.
(IT strategy, Nomination, Audit)
[ANS: 1)Two 2)Board of Directors 3)Board of Directors 4)Audit 5)Non-
Executive 6)Customer Service 7)Remuneration 8)Independent 9)CSR
10)IT Strategy]

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Banking Laws and
Operations - I

12.20 Further Readings & References

NOTES
1. M.L.Tannan, revised by : Banking Law and Practice, Wadhwa & Company,
Nagpur C.R. Datta & S.K. Kataria
2. A.B. Srivastava and : Seth's Banking Law, Law Publisher's India (P) Limited
K. Elumalai
3. R.K. Gupta : BANKING Law and Practice in 3 Vols. Modern Law Publications.

4 Prof. Clifford Gomez : Banking and Finance - Theory, Law and Practice, PHI
Learning Private Limited
5. J.M. Holden : The Law and Practice of Banking, Universal Law Publishing.

Banking Laws and

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 NOTES

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