An advance made by a bank is generally covered by primary or collateral securities. The effectiveness of the security depends on the nature of security. The securities can be classified into two aspects, economic and legal aspects. The economic aspect covers marketability, valuation, and other economic factors of the security. The other legal aspect is the validity and enforceability of the security. As per banking terms, the securities can be classified as Primary and Collateral.
Primary security is the asset created out of the credit facility extended to the borrower and/or which is directly associated with the business/project of the borrower for which the credit facility has been extended. Collateral security is any other security offered for the said credit facility. For example, hypothecation of jewelry, mortgage of the house, etc.
Attributes of good security are as follows:
- Title of the security: The borrower should have a good title to the security.
- Non-encumbrance: The security should not have any encumbrance or liability.
- Marketability: The security should be easily marketable.
- Ascertain ability: The value of security should be easily ascertainable.
- Stability of value: The security should not be liable to wide price fluctuation.
- Storability: Storing of the security should not be difficult.
- Transferability: The security should be easily and freely transferable.
- Durability: The security should be durable.
- Transportable: The security should be easily transportable.
Based on security, the loan may be classified as follows:
Unsecured advances don’t have supported by any collateral. The unsecured loans are given without any tangible security or assets but merely on the strength of the integrity of the “creditworthiness” of the borrower. Unsecured loans rely solely on the borrower’s credit history and his income to qualify for the loan. e.g.- Credit Card, Clean personal loan, Education loan (small), etc. In other words, creditworthiness is the confidence of a Banker in the future solvency of a person. They are also called clean loans.
The advance which is secured by any tangible security is called Secured Advances. A loan or advance made on the security of assets the market value of which is not at any time less than the amount of such loan or advance. In the event of a loan default, the lender can take possession of the asset and use it to cover the loan. e.g. Business loan, housing loan, etc.
VARIOUS KINDS OF SECURITIES
Bank accepts various kinds of tangible assets as security after creating the charge. Some important types of securities are as under:
Land & Building/Real Estate
It is common security accepted by the banks. During the lending bank mortgaged/creation of charged the landed property in favour of the bank. The advantage of these types of securities is that their value generally increases over time. It is fixed and cannot be shifted to another place. It can be freehold or leasehold property. Valuation of the property is required for acceptance as a security in the loan account. 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 disadvantages.
The advantage of collateral security of Land & Building are as under;
(i) The advantage that land has over other types of securities is that its 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.
(ii) It cannot be shifted, a fact which sometimes is also a disadvantage.
(iii) The securitisation of the mortgaged property can be done without court intervention under SARFAESI Act 2002.
The disadvantage of collateral security of Land & Building are as under;
(i) Valuation is at times difficult:
The value of a building depends on several factors such as location, size of property, amenities, etc., this makes the valuation very difficult. Buildings and the materials used in the buildings are not alike. Buildings must be valued on a conservative basis because of the limited market in the event of a 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. Title verification must also be done to know whether the property was encumbered. Bank’s advocate has to be done by verifying records 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 security.
(iii) Difficult to realize the security:
Land is not easily and quickly realizable, due to the lack of a 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. After the SARFAESI Act 2002, now the bank can securitize the mortgaged property without the intervention of the court.
(iv) Creating a charge is costly:
The security can be charged either by way of a 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. 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 a lot of formalities.
Precautions to be taken by the banker
Before an immovable property is accepted as security, the banker should take the following precautions.
(i) Borrower’s title:
The banker should get a penal advocate report to verify the title to the property and the right of the borrower to a mortgage. Advocate has to certify that the person in whose property stands has a good, valid, subsisting, and marketable title over the property, that the property is free from all encumbrances, and is not subject to any litigation or attachment from any court or statutory authorities.
(ii) Enquiry regarding prior charges:
The borrower should produce a certificate from the Registrar’s office listing the charges over the property over some time (generally 30 years) that the property is free from encumbrances. This is commonly understood as a non-encumbrance certificate. If any prior charges exist the banker’s right will be subject to such prior charges.
(iii) Freehold or leasehold:
A freeholder is the absolute owner of his land and can 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 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, the 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.
(iv) Valuation of the property:
Valuation of the property is necessary to consider as collateral security. Valuation should be done by bank-approved valuers who would be engineers or architects. The valuation report must be comprehensive, realistic and based on the following points.
a) The location and size of the property
b) Area of the land and building
c) The nature and cost of construction
d) Age of the building, Present status and future life
e) Tax and other obligations
The mortgage deed must be drafted carefully considering all the legal stipulations. It should be witnessed by at least two persons In the case of a simple mortgage it attracts ad-valorem stamp duty.
(vi) Verification of Tax Receipts:
The banker should request the borrower to produce late the st tax receipts since any arrears of tax constitute a preferential charge on the property.
(vii) Insurance of the property:
To avoid loss of security by fire, natural calamities, it is prudent that in the case of buildings the banker insists on the insurance of the property for its full value at the borrower’s expense.
The banker gets a tangible form of security, which in case of default by the borrower, can be realised realise thee le of pledged goods. Banker acquires a good title to the goods when dealing with customers of repute and then banking Bankers should take care while accepting the security of the good goods because certain goods are liable to perish or deteriorate in quality over some time thus resulting in a reduction of the value of the security. Advance against goods may be extended by way of goods as pledge or hypothecation. Advance is given based on the stocks and their value declared in the monthly stock statement. The stock statements must be verified by factory or godown inspection.
Merits of this Security:
Merits of this collateral security are as under;
- Goods have a ready market and as such can be easily sold unlike other kinds of security.
- Valuation of the goods can be easily done.
- The banker gets a tangible form of security compared to unsecured advances, which in case of default by the borrower, can be realized by the sale of pledged goods.
- Barring a few states where the stamp duty is heavy, creating a charge on the security is less costly and involves minimum formalities.
Demerits of this Security:
Demerits of this collateral security are as under;
- Certain goods are liable to perish or deteriorate in quality over a period, thus resulting in a reduction of the value of the banker’s security.
- 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.
- In some cases, the banker may find it difficult to store the goods.
- 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.
- 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.
Precautions to be taken while goods are considered as collateral security;
- Advances against goods should be restricted to genuine traders and not to speculators.
- Loans must be given for short periods since the quality and thereby the value of the security is likely to diminish.
- The banker must have a working knowledge and gather information of the several types of goods regarding their character, price movements, storage value, etc.
- The banker should confirm the state of goods.
- The goods should be insured against loss by theft or fire.
- The banker should verify and confirm the title of the borrower to the goods by inspecting the invoices or cash memos.
- The banker as a Pawnee is liable if reasonable care is not taken of the goods pledged. He should, therefore, take proper care of their storage and take reasonable steps to protect them from damage and pilferage.
- The price of the goods must be accurately ascertained.
- Necessary margin must be taken by the banker to protect him against fluctuations in the price of goods.
- The banker must obtain absolute or constructive possession of the goods.
- 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 if 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.
Inspection of stocks:
Inspection of the stock must be done regularly. Verification of hypothecated/pledged stock is required at regular intervals or monthly basis. In case goods are stored in bags, the inspecting official of the bank should count the number of bags and if necessary a few of the bags selected at random may be ordered to be opened to ensure that the goods stated to have been stored are held in bags.
Normally, valuation of the stock is done based on cost price or market price whichever is less.
Maintaining an adequate margin on the stock as stipulated in the sanction. Drawing power is calculated after deducting the margin to be maintained.
Documents of Title to Goods:
As per 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:
- The mere possession of the documents creates a right either by law or trade usage, to possess the goods represented by the documents.
- Goods represented by the documents can be transferred by endorsement and/or delivery of the documents.
- The transferee of the documents can take delivery of the goods in his own right.
- 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 the transferor. They may be called quasi-negotiable instruments.
Examples of documents of title to goods are bills of lading, dock warrant, warehouse keepers’ 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 a mere acknowledgement of the goods.
Merits of this Security
- By mere pledge of the instruments the goods are pledged and serve as good security.
- The person in possession of the document can transfer the goods by endorsement and/or delivery. The transferee thereafter is entitled to take delivery of the goods in his own right.
- The documents are easily transferable, and the formalities involved are less compared to mortgage or assignment.
Demerits of this Security
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.
Forged and altered documents:
The documents might be forged ones, or even if genuine, the quantity may be altered.
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.
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 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.
Precautions to be taken by the banker
- 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.
- The banker should ensure that the documents do not contain any onerous clauses or prejudicial remarks about the condition of goods received.
- Bankers should ensure that the goods are adequately covered by insurance for the 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.
- Banker should ensure to get consignee copy and banks name being entered as consignee, so that endorsement/transfer of title is specific.
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:
- The borrower on sale of the goods has to hold proceeds in trust for the banker.
- 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:
- Borrower’s recognition, of bank’s rights in the goods as security and case of a sale, the proceeds, thereof.
- Borrowers, undertaking to hold the goods or sale proceeds thereof, in trust for the banker.
- Borrower’s undertaking, to ensure proper storage and insurance, at his cost.
- Borrower’s undertaking to direct the buyer to pay the monies directly to the banker, if so required by the banker.
- Borrower’s undertaking to return unsold goods on banker’s request or dispose of the same as directed by the banker.
Life Insurance Policy:
A life insurance policy is generally taken for both financial security and saving purposes. The assignment of the policy in favour of the banker requires very few formalities and the banker obtains a perfect title. The policy is tangible security and in the custody of the bank. The security can be realised immediately on the borrower’s default of payment by surrendering the policy to the insurance company. In the event of the borrower’s death, the debt is easily liquidated from the proceeds of the policy.
- 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.
- The assignment of the policy in favour of the banker requires very little formalities and the banker obtains a perfect title.
- The longer the period for which the policy has been in force, the greater the surrender value. It is also useful as additional security because, in the event of the borrower’s death, the debt is easily liquidated from the proceeds of the policy.
- The security can be realized immediately on the borrower’s default of payment by surrendering the policy to the insurance company.
- The policy is tangible security and is in the custody of the bank. The banker only has to ensure that regular payment of premiums is made.
- If the premium is not paid regularly, the policy lapses and reviving the policy is complicated.
- Insurance contracts being contracts of utmost good faith, any misrepresentation or non-disclosure of any particulars by the assured would make the policy void and enable the insurer to avoid the contract.
- The person (proposer) who has obtained the policy must have an insurable interest in the life of the assured or the contract is void.
- The policy may contain special clauses, which may restrict the liability of the insurer.
- When the banker accepts a policy coming under Married Women Property Act he must ensure that all the parties sign in the bank’s form of assignment.
- There is a facility to obtain the duplicate policy if the original is lost. This can be misused by persons by obtaining duplicate policies. The banker should, therefore, verify that no duplicate policy has been issued and there are no encumbrances on the policy.
Precautions to be taken by the banker
- 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 the authorized office of the Insurance Company has noted the assignment.
- The bank should see that the age of the assured is admitted.
- The banker should ensure the regular payment of the premium.
Borrowers can take advance by assigning book debt in favour of the bank. The assignment must be in writing and signed by the transferor or his duly authorised agent. The assignment may be absolute or by way of charge. As an actionable claim include future debt, there can be a valid assignment of future debt as well. The value of a security depends on the solvency of the debtor and his right of set-off if any. The banker must enquire into both aspects.
Legal Implication of assignment
- The assignee can sue in his/ their name and can give a valid discharge
- The debtor can exercise any right of set-off against the assignee, which but for such transfer, he could have exercised against the assignor
- As an actionable claim includes future debts, there can be a valid assignment of future debts as well.
Precautions to be taken by the banker
- 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.
- 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
- The banker must serve notices of assignment on debtors, who must be asked to acknowledge its receipt and confirm:
- The amount of the debt
- His right of set-off, if any, and
- Whether he has received notice of prior assignments if any
- An undertaking from the borrower should be taken that the number of debts collected directly if any by him will be passed on to the banker, towards the loan account and operations in the account be controlled to ensure this compliance
- Where the book debts areas assigned by a joint-stock company, the charge must be registered with the Registrar of Joint Stock Companies.
Banks normally accepted only quoted shares as security. The value of the security can be ascertained easily and creating a charge on share is less expensive. In the case of debenture, a charge is created on the assets of the company issuing such debenture in favour of a trustee who is responsible to take care of the interest of individual investors.
The advantage of collateral security of Share are as under;
- Value of the security can be ascertained without any difficulty.
- In normal times, stocks and shares enjoy the stability of value and are not subject to wide fluctuations.
- Stocks and shares require very little formalities, for taking them as security.
- It is easier compared to real estate to ascertain the title, more so with the advent of depositories.
- Creating a charge of this is less expensive than real estate.
- They yield income by way of dividends, which can be appropriated towards the loan account.
- Being a tangible form of securities they are more reliable.
- The release of such securities involves very little expense and formality.
The disadvantage of collateral security of Share are as under;
(i) Being easy to realize, they are fraud-prone and as such, they must be 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:
Bankers must take the following precautions while advancing against stocks and shares. In the case of partly paid shares;
- The banker should never register them in his name.
- He must ensure that pending calls are paid.
- Sufficient margin should be taken to avoid any future loss or change in the value of the security.
- The banker should verify the share certificate and ensure that the calls, are paid properly and entered in the space provided for the same.
(i) Update the list of shares that the particular bank is willing to lend against regularly.
(ii) Updating the amount that can be leant 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.
- Term Deposit Receipt:
TDR is the most common security accepted by a bank. This security is certainly most valuable, as the money represented by the receipt is already with the bank. It is easy to know the present value and liquidation of a TDR. The banker normally grants the advance only to the person in whose name the money is deposited. A banker should not advance against the fixed deposit receipt of another bank. If a deposit is in the joint names the request for the loan must come from all of them.
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. In addition to this, the banker should obtain a letter of appropriation which authorises the banker to appropriate the amount of the deposit on maturity or earlier towards the loan amount. Bank has to lien the TDR before disbursement of the loan.
Precautions to be taken by the banker
- The banker should grant the advance only to the person in whose name the money is deposited. A banker should not advance against fixed deposit receipts of other banks.
- If, the deposit is in joint names the loan request must come from all of them.
- 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.
- Advance should preferably not be made against fixed deposit receipt in the name of a minor unless a declaration is taken from the guardian, that loan will be utilized for benefit of the minor.
- 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 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 default in repayment of instalment if any.
Supply bills arise about the transactions with the Government and public sector undertaking. A party might have taken a contract for execution, and he is entitled to progressive payment based on work done, for which he has to submit bills by the term and conditions of the contract. Similarly, parties who have accepted tenders for the supply of goods over a period are entitled to payment on the supply of goods, for which they submit bills by the term of the contract. These bills are known as supply bills. Advance against supply bills should be made only to borrowers who have sufficient experience in Government business and Government regulations. The banker should obtain a power of attorney from the supplier authorising him to receive the money. The same should be registered with an appropriate Government department.
Risks involved in advancing against supply bills
- 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.
- It is virtually a clean advance and the bank may not realize the full amount, because of the possibility of the counterclaim or the right of set-off by the Government, as the charge is only by way of assignment.
- 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.
Precautions to be taken by the banker
- Advances against supply bills should be made only to borrowers who have sufficient experience in Government business and Government regulations.
- 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.
- 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.
- 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.
- 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.
Banks give loans against gold ornaments for agriculture as well as non-agriculture purposes. Bank pledge the gold and allow loan or overdraft against the security of gold ornaments. Nowadays, banks also accept Gold bonds as security.
Bank accepts various types of deposit receipts such as NSC, KVP, UTI Bond etc as security and finance against them. The bank must create a charge on such paper during the financing.