Principles of Lending, Different Types of Borrowers, and Types of Credit Facilities
Principles & Practices of Banking | Unit B · Chapter 22
The six cardinal principles of lending, the eight legal categories of borrowers (individuals to LLPs), working capital concepts, fund-based facilities (cash credit, overdraft, bill finance, term loans) and non-fund based facilities (bank guarantees, letters of credit) — the foundation chapter of Module B.
📌 Why This Chapter Matters in JAIIB
Expect 4–5 questions from this chapter every attempt — it opens Module B (Functions of Banks) and everything from Chapter 23 to 41 builds on it. High-yield areas: the 6 cardinal principles (match-the-following), minor's contract is void (Sec 68 exception for necessities), consequences of non-registration of a partnership (Sec 69), Karta's unlimited liability, Salomon vs Salomon (separate legal entity), gross vs net working capital, the rule in Clayton's case, and fund-based vs non-fund based classification.
All Key Numbers — Chapter 22 at a Glance
The Six Cardinal Principles of Lending
Why Principles Matter
Lending is one of the prime functions of a banker — but the money a bank lends is not its own. It is largely borrowed funds (depositors' money) that must be repaid as per the tenure of the deposit. This is exactly why lending carries inherent risk and why every advance must pass a test of sound principles before sanction.
The six cardinal principles below are the classic exam list. Questions usually ask you to identify a principle from its description, so learn the one-line essence of each.
🧠 Mnemonic — The 6 Cardinal Principles
"Safe Lenders Profit from Purposeful, Diversified Security."
Safety — 'Safety First'
The most important principle. The banker is a custodian of public funds, so every advance must be safe — the money lent must come back. Repayment depends on three things about the borrower: (i) capacity to pay, (ii) willingness to pay, and (iii) income generation. A borrower may have capacity but no willingness (a character problem), or willingness but no income (a viability problem) — the banker must be satisfied on all three.
⚠️ Exam trap
If the exam asks 'the MOST important principle of lending', the answer is Safety — not security or profitability.
Liquidity
Money lent should not get locked up for a long time — bank deposits are essentially short-term, so the bank must be able to get its money back when needed. If a loan goes bad, the bank recovers by selling the assets charged to it; therefore the assets must have marketable / saleable value covering the loan dues.
⚠️ Exam trap
Liquidity is about the BANK's ability to recall funds and the SALEABILITY of charged assets — don't confuse it with the borrower's liquidity ratios.
Profitability
Banks are commercial organisations — a fair return is essential. A margin of roughly 3–4% between lending and borrowing rates is needed to meet administrative expenses. Pricing depends on the category of advance and the credit rating / risk perception of the borrower. Banks should look at overall profitability from ALL businesses of a customer, not each product in isolation — a Customer Profitability Analysis (CPA) helps price products: a customer unremunerative on one service may more than compensate on another.
⚠️ Exam trap
CPA = Customer Profitability Analysis — a direct one-liner MCQ.
Purpose
Banks lend for productive purposes, not merely because someone asks. Loans for undesirable and speculative purposes cannot be granted, and RBI has specified certain prohibited sectors for lending. Banks DO also lend for consumption purposes — personal loans, medical and education expenses, travel, vehicles, housing loans, etc.
⚠️ Exam trap
'Banks never lend for consumption' is FALSE — consumption lending (personal loans, housing, vehicles) is permitted; speculative lending is not.
Diversification of Risks
Avoid concentration risk — do not over-expose the bank to a single borrower or group, a single purpose/industry, or a single geography. Industries face business cycles and commodity price swings; political disturbances or natural calamities (earthquakes, floods) can paralyse a region; and in a globalised market, failure in one sector spreads to others — the global economic meltdown triggered by the sub-prime crisis is the textbook example.
⚠️ Exam trap
Concentration risk = single borrower/group, purpose, or geography. All three dimensions count.
Security
Security may be land, a building, a flat, a shop, ornaments, insurance policies, shares, debentures, bonds — or sometimes nothing except the borrower's personal commitment. The key doctrine: security is only a CUSHION to fall back upon in case of need. The security and its adequacy alone should never be the sole consideration for judging the suitability of a loan.
⚠️ Exam trap
'A loan can be sanctioned purely because security is adequate' — FALSE. Security is a cushion, not the basis of the decision.
💡 Also know — the 7 Cs of Credit
Besides the six cardinal principles, the 7 Cs of Creditis another conceptual framework used by financial institutions and non-bank lenders to assess a borrower — covering dimensions such as Character, Capacity, Capital, Collateral, Conditions, Credit history and Common sense. If the question mentions "7 Cs", it is testing this borrower-assessment framework, not the cardinal principles.
Types of Borrowers — Individuals & Proprietorship Firms
The 8 Categories of Borrowers
Each category is governed by a different law — matching the borrower to the governing Act is a guaranteed exam question. Individuals and proprietorships → Indian Contract Act 1872; partnerships → Indian Partnership Act 1932; HUF → customary Hindu law / Hindu Succession Act; companies → Companies Act 2013; LLPs → LLP Act 2008.
Individuals — Competence to Contract Is Everything
A bank can lend to any individual of sound mind who is competent to contract. Money lent to an incompetent person cannot be recovered — so the exam focuses on who is NOT competent:
Minor (below 18 — Indian Majority Act)
A contract entered into by a minor is VOID. Assets pledged against an advance to a minor are not available for appropriation of dues. Exception: if money is lent to a minor for necessities of life, Section 68 of the Indian Contract Act makes the minor's PROPERTY/ESTATE liable (the minor is never personally liable). Guardians may borrow on behalf of minors.
Person of unsound mind (Sec 12, Indian Contract Act 1872)
A person is of sound mind if, at the time of contracting, they can understand the contract and form a rational judgement of its effect on their interests. A contract made by a person who could not understand what they were doing is invalid.
Disqualified person (Sec 11, Indian Contract Act)
Statutory disqualifications may bar a person from contracting — e.g. an undischarged insolvent cannot enter into a contract so long as the insolvency continues; such contracts are not enforceable.
Married woman
Law does NOT debar a married woman from seeking an advance — she is treated like any other individual borrower.
Pardanashin woman
One who observes complete seclusion per the customs of her community. She IS competent to contract and can get an advance sanctioned — but practical risks exist: a plea of undue influence may be raised, or her identity may even be denied. Banks take additional measures and precautions in such cases.
Illiterate person
Fully competent to contract. Executes documents by thumb impression — a thumb impression is a 'mark', and signature includes a mark by a person unable to write their name. If both hands are lost, the toe (foot thumb) impression is used. Documents should be read out and explained before witnesses, whose names and addresses are kept on record, with a duly witnessed recital held with the documents.
⚠️ Exam trap — minor's loan
A minor's contract is void (not voidable). Under Sec 68, only the minor's estate is liable for necessities — the minor is never personally liable. Both distinctions are tested as True/False items.
Proprietorship Firm
- →A business wholly owned by ONE individual — dealings are essentially dealings with the owner, governed by the Indian Contract Act.
- →In accounting, the business is treated as distinct from the owner (to avoid mixing personal and business transactions) — but in LAW there is no separation.
- →Liability of the sole proprietor is UNLIMITED: creditors have recourse to both business assets and the proprietor's private assets.
- →Common lending issue: absence of proper accounts and of segregation between the individual's account and the business.
💡 Example
Ramesh runs "Sharma Kirana Store" as sole proprietor and takes a ₹10 lakh business loan. The shop fails. The bank can recover not only from shop stock and fittings but also from Ramesh's personal house and savings — that is unlimited liability. Had it been a private limited company, recovery would stop at the company's assets.
Partnership Firms — The Heaviest-Tested Borrower Type
Definition & Legal Position
Section 4, Indian Partnership Act 1932: partnership is the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all. Dealings with a firm are also governed by the Indian Contract Act.
A partnership is not distinct from its partners (unlike a company). Section 18: a partner is the agent of the firm for the purpose of the business of the firm — so an act done by a partner in the usual course of business binds the firm.
| A partner CAN (implied authority — trading firm) | A partner CANNOT (no implied authority) |
|---|---|
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Essential Ingredients of a Partnership
- →Association of TWO or more PERSONS (firms cannot be partners). Maximum: Sec 464(1) of Companies Act 2013 permits prescribing up to 100; the Companies (Miscellaneous) Rules 2014 have prescribed 50. Exceeding the limit without registering as a company makes the association illegal.
- →An express or implied AGREEMENT between partners to do business for gain.
- →There must be a BUSINESS — trade, occupation or profession — and it must be legal.
- →SHARING of profits and losses (a partner may, by distinct understanding, share only profits).
- →Business carried on by ALL or by ANY of them acting for all (mutual agency).
⚠️ NOT partnerships
A society, an association, a club, a joint Hindu family, and a co-ownership are not partnerships — a favourite "which of these is a partnership" MCQ.
Registration of a Firm — Optional but Critical
The Partnership Act provides for registration but does not make it mandatory. Application goes to the Registrar of Firms within one year of forming, in the prescribed form with the fee, stating: firm name, principal place of business, other places of business, date of joining of each partner, full names and permanent addresses of partners, and duration of the firm. The Registrar records the entry in the Register of Firms and grants a certificate of registration. Changes, dissolution and withdrawal of a minor are also recorded; the Registrar can rectify mistakes. Any person signing a false or incomplete statement is punishable with imprisonment up to 3 months, or fine, or both.
Consequences of NON-registration (Sec 69)
- 1.Partners cannot sue each other or the firm to enforce a contractual right or a right under the Partnership Act.
- 2.The firm cannot sue any THIRD PARTY to enforce a right arising from a contract (the persons suing must also be shown as partners in the Register of Firms).
- 3.The bar applies only to contractual rights — NOT to other rights (e.g. enforcing a negotiable instrument, ejecting a landlord).
- 4.Exceptions: suit for dissolution / accounts of a dissolved firm / realising property of a dissolved firm; powers of an official assignee or receiver under insolvency law; and small-cause suits not exceeding ₹100.
Third parties CAN still sue the unregistered firm — the disability is one-way. This is the single most-tested point on partnerships.
Insolvency, Death & the Banker's Response
Insolvency of the FIRM
Stop all further transactions immediately — whether the account is in credit or debit. Credit balance (if not set off) goes to the Official Receiver as directed by the Court; if in debit, the bank proves its debt before the Court and receives payment in full or as per the dividend declared.
Insolvency of a PARTNER
If the firm's account is in CREDIT, the other partners can operate it — the bank obtains a fresh mandate. If in DEBIT, stop further transactions so that the rule in Clayton's case does not apply (fresh credits would otherwise wipe out the insolvent partner's liability).
Death of a PARTNER
On notice of death, stop transactions in a running facility (cash credit / overdraft) to CRYSTALLISE the deceased partner's liability and keep their estate liable. The bank may allow operations in a SEPARATE account so the firm's business is not disrupted.
✅ Banker's checklist before lending to a firm
- 1. The firm should be a registered one.
- 2. Scrutinise the partnership deed for provisions that may jeopardise the loan (borrowing powers, managing partner's authority — obtain consent of all partners where the deed does not empower the managing partner).
- 3. If one partner is a limited company, register the bank's charge with the ROC.
- 4. For an equitable mortgage, the memorandum of deposit must be signed by ALL partners; a legal mortgage needs concurrence of all partners (Sec 19).
HUF, Companies, Statutory Corporations, Trusts & LLPs
Hindu Undivided Family (HUF)
An HUF consists of all persons lineally descended from a common ancestor, including their wives and unmarried daughters. It cannot be created under a contract — it arises from family status — yet it is a separate entity for Income-tax assessment (Sec 2(31), Income-tax Act 1961) with its own PAN. An HUF is not a "person" in law but a group of persons.
Two schools: under Mitakshara law a coparcener acquires a right in ancestral property by birth; under Dayabhaga law (Bengal region) the son acquires the right for the first time on the father's death. Succession among Hindus is codified by the Hindu Succession Act 1956 — which applies to Hindus (including Virashaiva, Lingayat, Brahmo/Prarthana/Arya Samaj followers), Buddhists, Jains and Sikhs, and to anyone who is not a Muslim, Christian, Parsi or Jew.
The Hindu Succession (Amendment) Act 2005 gave daughters equal coparcenary rights — so a daughter is a coparcener, and in the absence of an adult male member, a female member can become Karta.
The Karta — Powers & Liability
- →Senior-most member manages family property/business; the position comes by birth, not by consent of the coparceners. A male minor can act as Karta through his natural guardian.
- →Karta's liability is UNLIMITED; coparceners' liability is limited to their share in the joint family estate — unless they join or ratify the contract, when they become personally liable.
- →Karta can borrow for the family or ancestral business — but the burden of proving legal necessity lies on the LENDER (the bank).
- →Alienation of HUF property by the Karta without legal necessity is not void but VOIDABLE at the option of the other coparceners.
- →Bank practice: obtain the HUF letter and get documents executed by the Karta AND all adult coparceners, making all adult members jointly and severally liable.
⚠️ Exam trap — burden of proof
The burden of proving that a loan to the Karta was for family necessity is on the lender (bank) — not on the Karta or coparceners.
Companies — Separate Legal Entity
A company is a juristic person created by law (now the Companies Act 2013), with perpetual succession, distinct from its members. The foundation case is Salomon vs Salomon & Co. Ltd. (1897): Mr Salomon incorporated his boot business with seven family members, held nearly all shares plus secured debentures; on liquidation the House of Lords held the company is in law a different person altogether from its shareholders — even a person holding virtually the entire capital is not liable for the company's acts. The case also established limited liability. The Supreme Court affirmed the principle in Tata Engineering & Locomotive Co. vs State of Bihar (AIR 1965 SC 40).
Characteristics
- → Perpetual succession — only law can dissolve it
- → Shares freely transferable (subject to restrictions in a private company)
- → Members' liability limited to unpaid value of shares (or amount guaranteed)
- → Owns property in its own name; can sue and be sued
- → Common seal is now OPTIONAL — documents may instead be signed by two directors, or one director + company secretary
MoA vs AoA
- → Memorandum of Association — the CHARTER: name, State of registered office, objects, liability, share capital. Defines the area within which the company can act; the bank must examine it.
- → Articles of Association — internal rules, SUBORDINATE to the MoA: directors, meetings, share transfers, BORROWING POWERS, officers.
- → Name must end "Limited" (public) / "Private Limited" (private); a Section 8 company may drop "Limited" with a licence.
| Type of company | Key exam facts |
|---|---|
| Private company | By its Articles: restricts transfer of shares, limits members to 200 (except OPC), prohibits public invitation to subscribe to securities. |
| Public company | Not a private company — shares freely transferable, public can participate, no member ceiling. A subsidiary of a public company is DEEMED public even if its articles say private. |
| One Person Company (OPC) | Only one member. Loses OPC status if paid-up capital exceeds ₹50 lakh OR average annual turnover exceeds ₹2 crore in three immediately preceding consecutive years. |
| Government company | Central/State Government(s) hold not less than 51% of share capital; includes a subsidiary of a Government company. |
| Small company | Non-public company with paid-up capital ≤ ₹50 lakh AND turnover ≤ ₹2 crore (per last P&L). Excludes holding/subsidiary companies, Section 8 companies and bodies under special Acts. |
| Holding / Subsidiary | Holding company controls Board composition OR more than half the total voting power (alone or with subsidiaries). Control of Board = power to appoint/remove all or a majority of directors. |
| Foreign company | Has a place of business in India (itself/agent, physical or electronic) AND conducts any business activity in India. |
⚠️ Commencement of business (2019 amendment)
A company with share capital cannot commence business or exercise borrowing powers unless (a) a director files a declaration within 180 days of incorporation that every subscriber has paid for their shares, AND (b) the company has filed verification of its registered office. The company comes into being on the date in the Certificate of Incorporation.
Statutory Corporations
- →Created by their own Acts and governed by those Acts.
- →SBI — State Bank of India Act, 1955.
- →Nationalised banks — Banking Companies (Acquisition & Transfer of Undertakings) Acts, 1970 and 1980.
Trusts, Societies & Clubs
- →Private trusts — Indian Trusts Act 1882; public trusts — Public Trusts Act; Hindu religious trusts — Religious & Charitable Endowments Act; Muslim trusts — Wakf Act (trustee = Mutawali, regulated by the Wakf Board).
- →Charity Commissioners / Commissioner of Endowments supervise public trusts — ensure all Government permissions for borrowing are obtained.
- →Account-opening documents: registration certificate, trust deed, PAN/Form 60, and documents on beneficial owners / attorney holders.
- →For clubs, societies and schools: study the bye-laws and rules to ascertain the legality of lending.
Limited Liability Partnership (LLP Act, 2008)
- →A BODY CORPORATE separate from its partners, with perpetual succession — change in partners does not affect its existence, rights or liabilities.
- →Minimum 2 partners (individuals or bodies corporate); minimum 2 DESIGNATED partners, of whom at least ONE must be resident in India.
- →An individual cannot be a partner if: found of unsound mind by a Court (finding in force), an undischarged insolvent, or has a pending application to be adjudicated insolvent.
- →In its own name it can acquire/hold/dispose property, enter contracts, sue and be sued.
- →The LLP is liable to the FULL extent of its assets; each partner's liability is limited to the agreed contribution. No partner is liable for the independent or unauthorised acts of other partners.
- →Small LLP: contribution ≤ ₹25,00,000 AND preceding-year turnover ≤ ₹40,00,000.
💡 Account-opening documents for an LLP
Certificate of incorporation of the LLP, PAN of the LLP, registered office address proof, PAN and address proofs of all partners, the LLP agreement, and any other document the bank specifies.
Types of Credit Facilities & the Working Capital Concept
| Fund-based (bank's money flows out) | Non-fund based (contingent — no immediate outflow) |
|---|---|
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Retail vs Commercial Segmentation
Banks commonly segregate the loan portfolio by customer segment. Retail loans — vehicle, home, education, credit cards, personal loans, consumer durables, small business loans. Commercial loans — larger amounts, individually assessed and monitored; classified into Term Loans (fixed repayment schedule) and Working Capital loans (payable on demand — shown as current assets in the BANK's balance sheet).
What Is Working Capital?
Working capital is the money an enterprise needs for day-to-day operations: purchase of raw materials, stores and spares; wages; energy, fuel, water, statutory dues, rates, taxes and carriage; and other production, selling and administration expenses. It is fluctuating by nature — driven by the operating cycle and the seasonality of the business — so the funding need keeps changing daily.
Gross Working Capital
Total working funds requirement — funded by borrower's margin + sundry creditors and other current liabilities + bank finance.
Net Working Capital
Excess of total Current Assets over Current Liabilities — i.e. the portion of current assets funded by LONG-TERM funds (owned funds: paid-up capital + reserves including current-year profit; plus term loans/debentures).
⚠️ Adequacy & the risk–return trade-off
Excessive working capital = idle funds, no profit. Inadequate = production interruptions, reduced profitability, even losses. Higher current-assets-to-total-assets ratio → lower risk of technical insolvency but lower profitability (current assets are less profitable than fixed assets; short-term funds are cheaper than long-term). Lower ratio → higher profitability, higher risk. This inverse relationship is a repeat MCQ.
Need for Long-Term Funds
Fixed assets (land, factory, machinery, deposits for utilities) need long-term funding — own resources supplemented by institutional/bank finance, typically amortised over 3–7 years from the surplus generated, extending to 15–20 years for high-investment enterprises. Banks also extend term loans to fund the core (minimum) portion of working capital — the Working Capital Term Loan — which, as it is repaid, is progressively replaced by the borrower's own funds, enhancing the working-capital margin.
Term Loans vs Working Capital Facilities
| Feature | Term loan | Working capital facility |
|---|---|---|
| Purpose | Acquisition of fixed assets (land, building, machinery) | Day-to-day operations — stocks, receivables, expenses |
| Duration | Medium/long term; repaid in monthly/quarterly/half-yearly instalments | Typically sanctioned for 1 year; renewed at the end of the validity period |
| Disbursement | Once, or a few tranches during project implementation; no further disbursement after that | Running account with frequent drawings and credits |
| Repayment | Instalments commence once the unit generates surplus | Repayable ON DEMAND; can remain fully drawn during validity |
| Nature | Self-extinguishing as instalments are paid | Short-term in form, but PERMANENT in nature — continues as long as the unit operates |
Cash Credit, Overdraft, Clayton's Case & Bill Finance
Cash Credit vs Overdraft
Both are running accounts with a sanctioned limit. The only real difference is the normal balance: a cash credit account normally stays in DEBIT (it is a regular funding source, occasionally going into credit), while an overdraft is a current account with a borrowing facility — normally in CREDIT, used when the need for finance is intermittent.
The customer draws only what is needed, when needed — interest is charged on the actual amount drawn on a day-to-day basis, which reduces borrowing cost. Drawings are regulated by the Drawing Power (DP) = market value of current assets (raw materials, work-in-process, finished goods, often receivables not covered by bill finance) minus margin at the prescribed rate.
💡 Example — Drawing Power
Stock value ₹10 lakh, margin 25% → DP = ₹7.5 lakh. Even if the sanctioned limit is ₹9 lakh, the borrower can draw only ₹7.5 lakh. Drawings are capped by the LOWER of limit and DP.
Implied contract of overdraft — Bank of Maharashtra vs United Construction Co. (1986)
A customer overdrew his account with no written overdraft contract, then refused to pay interest. The Bombay High Court held there is no need for an EXPRESS contract — an overdraft contract can be implied, and the borrower must repay with interest. So a cash credit/overdraft contract may be express OR implied.
The Rule in Clayton's Case — appropriation of payments
In a running account, each DEBIT is a separate loan and each CREDIT repays the EARLIEST debit — first money in discharges the first item on the debit side. Example: debits of ₹1,000 (3 March) and ₹500 (6 March); the borrower pays ₹750 on 12 March → it is appropriated first against the earlier ₹1,000 debit, reducing it to ₹250, not against the later ₹500.
⚠️ Why banks care
The rule creates recovery problems (e.g. on death/insolvency of a partner, fresh credits would silently extinguish old debits and release the estate). Banks avoid it by agreeing on the method of appropriation and treating all debits as ONE debt — and by stopping the account on notice of death/insolvency to crystallise the liability.
Temporary overdraft cannot be terminated at the bank's sweet will
A firm enjoyed an overdraft facility for four years with no written agreement or security. The bank unilaterally terminated it without notice and dishonoured the firm's cheque. Courts (up to the High Court) awarded damages for wrongful dishonour: the conduct of parties over four years implied a contract, and a temporary overdraft cannot be terminated unilaterally without giving the constituent notice.
Bill Finance — Self-Liquidating Working Capital
Bill finance funds the borrower's receivables on individual sale transactions — the advance is liquidated when the buyer pays the bill, making it self-liquidating. Where bill finance is granted, the cash credit limit is correspondingly lower (it then covers stocks only). Five methods — the first four are fund-based, the last is non-fund based:
1. Bill discounting
USANCE bills drawn by the borrower on the buyer are discounted; the borrower gets the bill amount less discount and charges. The discount is interest for the unexpired credit period agreed between borrower and buyer.
2. Bills purchase
For bills payable on DEMAND (no credit period). Bank pays the bill amount less charges; proceeds go to the borrower's CC/OD account. Delayed payment attracts additional interest for the delay.
3. Advance against bills for collection
Instead of financing each bill, a CC/OD facility is extended against the pool of bills under collection. DP = total bills under collection LESS margin (unlike discounting/purchase, this facility carries a margin).
4. Drawee bill acceptance
Finance to the BUYER side: bank pays the seller/seller's bank immediately on the buyer's acceptance of the bill — a facility for purchasing goods on credit, usually run as a CC/OD; the customer's payment on the due date liquidates it.
5. Bills co-acceptance (NON-fund based)
Bank adds its co-acceptance to bills accepted by the borrower — works like a bank guarantee/letter of credit, giving the seller comfort on credit sales; the seller may then get the co-accepted bill financed by a bank.
⚠️ Exam trap — usance vs demand
Discounting = usance bills (credit period); purchase = demand bills (payable immediately). Swapping these two is the classic wrong answer.
Term Loans, Their Law & Non-Fund Based Facilities
Term / Demand Loans — Classification
Short-term
Repayable within 1 year — not for capital expenditure; used for seasonal/contingent shortfalls in working capital (demand-loan nature).
Medium-term
Above 1 year and up to (and inclusive of) 5 years.
Long-term
Above 5 years. With term-lending institutions converted into banks, banks now do long-term finance too; housing loans run 20–30 years.
Term loans are disbursed in one lump sum (or a few tranches) and repaid in instalments per the schedule in the loan agreement and sanction letter. Demand loans are repayable on demand, with repayment as agreed with the bank.
Law Relating to Term Loans
Acceleration clause — P.K. Achuthan vs State Bank of Travancore (1974 KLT 806 FB)
The Kerala High Court upheld the clause that on default of ANY instalment, the lender may recover the whole debt including future instalments in one lump sum. Acceleration of repayment is legal.
Limitation for a recovery suit
For term loans: 3 years from the date of default of each specific instalment. The bank may wait until the last instalment falls due and sue for the whole amount — but if earlier defaulted instalments have crossed 3 years by then, the bank loses its right against those time-barred instalments. For a demand loan, the limitation is likewise 3 years.
Non-Fund Based Facilities — Contingent Liabilities
No immediate outflow of funds — the bank undertakes to pay only if a contingency happens. Four types: (a) Bank guarantee, (b) Letter of credit, (c) Underwriting & credit guarantee, (d) Derivative products.
(a) Bank Guarantee — Sec 126, Indian Contract Act 1872
Three broad kinds: performance guarantees, financial guarantees (both typically for working capital needs) and deferred payment guarantees (for capital goods / long-term liabilities). Specific types issued around contracts:
In large contracts, the buyer can invoke a performance guarantee on the supplier's failure or default and get compensated for financial losses.
(b) Letter of Credit
A written instrument issued by a banker at the request of the buyer (applicant) in favour of the seller (beneficiary), undertaking to honour documents/drafts drawn by the seller in accordance with the terms of the credit within a specified time. Banks follow the UCPDC 600 rules framed by the International Chamber of Commerce. Used mostly in trade finance — lets the borrower buy goods on credit without advance payment. LC usage has been declining in recent years.
(c) Underwriting & credit guarantee
Bank must provide funds/pay if the borrower fails to raise money or repay. Largely moved to merchant banking.
(d) Derivative products
Cover currency and interest-rate risks; they carry financial exposure on the customer, so they count as non-fund based credit support.
Other Credit Facilities — Consumer Credit / Retail Assets
Besides commercial credit, banks lend to individuals for personal needs — goods and services, education, medical, housing, consumer durables, vehicles, travel and leisure. Product shapes: one-time short/medium/long-term loans repayable in instalments, and revolving credit that can be drawn and repaid regularly (credit cards). This "Consumer Credit" or "Retail Asset" business contributes significantly to bank profitability.
Check Your Progress — Answers Explained
Q1 — (c) Indian Contract Act
Individual borrowers (and proprietorship firms) are governed by the Indian Contract Act, 1872 — competence to contract (Sec 11/12) is the threshold test.
Q2 — (b) Transferable
Shares of a public limited company are freely transferable; only a PRIVATE company restricts transferability by its Articles.
Q3 — (a) Fund based facility
Cash credit involves actual outflow of the bank's funds — fund based. Non-fund based = BG, LC, acceptance/co-acceptance.
Q4 — (a) Requirements for the day-to-day transactions
Working capital = funds for day-to-day operations. Note: NET working capital is current assets MINUS current liabilities — option (b) inverts it.
Q5 — (c) Both (a) and (b)
Performance and financial guarantees (and LCs) serve working capital needs, while the DEFERRED PAYMENT guarantee covers capital goods / long-term purposes — so non-fund based facilities serve both.
✅ Exam Strategy — Chapter 22 (Principles of Lending)
- 1.6 cardinal principles: Safety, Liquidity, Profitability, Purpose, Diversification of Risks, Security. Safety is the MOST important; security is only a cushion, never the sole consideration.
- 2.Repayment depends on: capacity to pay + willingness to pay + income generation.
- 3.Margin needed between lending and borrowing rates ≈ 3–4%. CPA = Customer Profitability Analysis.
- 4.Minor's contract = VOID; only the minor's ESTATE is liable for necessities (Sec 68 ICA). Sound mind = Sec 12; competence = Sec 11.
- 5.Married, pardanashin and illiterate persons CAN all borrow — with extra precautions for pardanashin (undue influence plea) and illiterate (thumb impression = mark, read out before witnesses).
- 6.Sole proprietor's liability is UNLIMITED — personal assets are also liable.
- 7.Partnership: Sec 4 (definition), Sec 18 (partner = agent of firm), Sec 19 (no implied authority to mortgage), Sec 69 (non-registration bars the firm's suits, but third parties can still sue the firm).
- 8.Max partners: 100 permitted under Sec 464 CA 2013; 50 prescribed by Rules 2014. Registration application: within 1 year of forming.
- 9.A partner CANNOT give a guarantee, refer disputes to arbitration, or execute a mortgage alone.
- 10.Death/insolvency of a partner with account in DEBIT → stop the account to avoid Clayton's case and crystallise liability.
- 11.HUF: Karta's liability UNLIMITED, coparceners limited to their share. Burden of proving legal necessity is on the LENDER. Alienation without necessity = VOIDABLE. Post-2005, daughters are coparceners and a female can be Karta.
- 12.Mitakshara = right by birth; Dayabhaga = right on father's death.
- 13.Salomon vs Salomon (1897) = separate legal entity + limited liability; affirmed in India by TELCO vs State of Bihar (1965).
- 14.Private company: max 200 members. OPC exit limits: ₹50 lakh capital / ₹2 crore turnover. Small company: ≤ ₹50 lakh capital AND ≤ ₹2 crore turnover. Government company: ≥ 51%.
- 15.MoA = charter (external boundary); AoA = internal rules, subordinate to MoA. Commencement declaration within 180 days of incorporation.
- 16.SBI = SBI Act 1955; nationalised banks = Acquisition Acts 1970 & 1980. Muslim trust trustee = Mutawali (Wakf Board).
- 17.LLP: min 2 partners, 2 designated partners (1 resident in India); partners' liability limited to agreed contribution; small LLP = ₹25 lakh contribution / ₹40 lakh turnover.
- 18.Gross WC = total working funds; Net WC = current assets − current liabilities (portion funded long-term).
- 19.Higher current-assets ratio → lower risk, LOWER profitability (and vice versa).
- 20.CC normally in debit; OD normally in credit — otherwise identical running accounts. Interest only on the amount actually drawn. DP = current assets value − margin.
- 21.Overdraft contract can be IMPLIED (Bank of Maharashtra vs United Construction, 1986); a temporary OD cannot be cancelled without notice.
- 22.Clayton's case: first credit discharges FIRST debit — banks contract out by treating all debits as one debt.
- 23.Bill discounting = USANCE bills; bills purchase = DEMAND bills; advance against bills for collection carries a MARGIN; co-acceptance is NON-fund based.
- 24.Term loans: short ≤ 1 yr, medium 1–5 yrs, long > 5 yrs; housing 20–30 yrs. Acceleration clause is valid (P.K. Achuthan case). Limitation = 3 years per defaulted instalment.
- 25.Non-fund based = contingent liability: BG (Sec 126 ICA), LC (UCPDC 600, ICC), underwriting, derivatives. Deferred payment guarantee = capital goods.
Discussion
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