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Introduction to Banking

Part II

Time Deposits, Advances, Trade Finance

Version 1.0

TATA Consultancy Services

March 2002Mumbai

Introduction to Banking - Part II Version 1.0

Tata Consultancy Services Confidential 1 of 47

Table of Contents

1. ABOUT THIS DOCUMENT...................................................................................................... 2

1.1 PURPOSE........................................................................................................................21.2 ORGANIZATION OF THIS DOCUMENT .................................................................................2

2. TIME / TERM DEPOSITS ........................................................................................................ 3

2.1 FIXED / TERM DEPOSITS ..................................................................................................72.2 RECURRING DEPOSITS ..................................................................................................112.3 FLEXI DEPOSITS............................................................................................................112.4 DEPOSIT SCHEMES FOR INDIANS ABROAD ......................................................................122.5 TAX CONSIDERATIONS...................................................................................................14

3. LOANS AND ADVANCES..................................................................................................... 15

3.1 CONCEPTS....................................................................................................................153.2 PRINCIPLES FOR LENDING..............................................................................................163.3 TYPES OF LOANS/ADVANCES .........................................................................................173.4 CREDIT PROCESS IN A BANK ..........................................................................................223.5 BANKING ARRANGEMENT ...............................................................................................253.6 FACTORS LIMITING LEVEL OF BANK’S ADVANCES ............................................................253.7 CLASSIFICATION OF ADVANCES AND PROVISION FOR NON-PERFORMING ASSETS.............263.8 DICGC GUARANTEE FOR SMALL LOANS ........................................................................273.9 PROCEDURES FOR MAINTENANCE OF LOAN ACCOUNTS ...................................................273.10 CLOSING OF LOAN ACCOUNTS .......................................................................................283.11 MIS & STATUTORY REPORTING TO RBI .........................................................................283.12 DEFICIENCIES / LIMITATIONS OF THE MANUAL SYSTEM .....................................................28

4. BILLS ..................................................................................................................................... 30

4.1 CONCEPTS....................................................................................................................304.2 DOCUMENTATION ..........................................................................................................324.3 BILLS OF EXCHANGE......................................................................................................33

5. LETTER OF CREDIT ............................................................................................................. 38

5.1 CONCEPTS....................................................................................................................385.2 COMMON TERMINOLOGY................................................................................................395.3 PROCEDURES FOLLOWED FOR OPERATIONS RELATED TO LETTER OF CREDIT ...................40

6. GUARANTEES ...................................................................................................................... 43

6.1 BANKING TERMS, CONCEPTS, PRACTICES GOVERNING BANK GUARANTEES.....................436.2 PROCEDURES FOR MAINTENANCE OF GUARANTEE ACCOUNTS ........................................45



1. ABOUT THIS DOCUMENT

1.1 Purpose

The objective of this document is to provide a basic understanding of the various operations ina bank / branch and familiarize the reader with the various banking terminology, the functionsand operations performed by the various departments in a branch. The focus in on the manualprocesses preformed at a branch as this will help in understanding the operations from abanker’s perspective. Computerization has changed the way in which some of theseoperations are performed today. However, once the reader has the understanding of themanual procedures, it will be easy for him/her to map it on to the automated processes.

This document is a part of the training material for fresh entrants into the banking group. Also,the persons responsible for the implementation of Banking solutions could also use this as areference material. It is recommended that the reading be taken up in the order specified.

1.2 Organization of this Document

This document is organized based on the various functions performed at the branch. It alsoprovides a very basic tutorial on the accounting concepts as is applicable to the bankingindustry. This document is organized in three parts for sake of convenience. It is advisable forbeginners to read this document in the order it has been presented.

Part I

• What is Banking• Accounting Concepts• Savings Account• Current Account• Cash Credit / Overdraft Accounts• Inland Remittances• Cash Department Procedures

Part II

• Time Deposits• Loans• Bills• Letter of Credit• Guarantees

Part III

• Introduction to Foreign Exchange• Exports• Imports• Foreign Remittances• Forward contracts

This is the second part (Part II) of the Introduction to Banking.



2. TIME / TERM DEPOSITS

A customer having idle/surplus funds with him would like to invest it somewhere, which wouldensure him sufficient returns, safety and liquidity. There are various possible avenues for himto invest the funds. One would be to keep in a bank as deposit for a certain period, other willbe to invest in stock market, another option might be to keep as deposit with a company andso on. Thus depending upon the risk he is ready to bear, the returns on investment will varyaccordingly. For example risk of investment in stock market is high but the returns on it mightalso be far more than that kept in bank as a deposit. A general tendency of any human beingis to take minimum risk and have stable returns on the investment. Hence a deposit placedwith the bank is the most stable income. Since the default on part of bank is a bare minimum,he normally tends to invest his funds in the bank as a term/fixed deposit.

• Term deposit is a contract between the bank and the customer specifying theamount of the deposit, the duration of the deposit and the return on the deposit(rate of interest)

A Term Deposit placed with a bank, is an agreement between the customer and the bank,whereby, the customer deposits certain amount with the bank for a certain period, and againstthis deposit placed with the bank, the bank agrees to pay interest at an agreed percentagerate to the customer.

When a customer places a deposit with the bank, he enters into a contract with the bank tomaintain the deposit with him for a certain period at certain specified rate of interest. Thus it isa liability on the part of bank since it owes the money to the depositors and have to pay themback after fixed time duration decided by the period of the deposit. As a result they arereferred to as ‘Time Liabilities’.

However, due to some reasons, the customer might want to withdraw the money earlier. Insuch cases, banks pay the money back but charges a penalty of 1% on such earlywithdrawals.

Thus Term Deposit does not offer to the customer, the kind of liquidity that a deposit in aSavings Account offers; but the interest rate is much higher for Term Deposit.

Banks have launched innovative schemes that offer a higher interest rate than a SavingsAccount and also liquidity. This has been achieved by tailoring products under Term Depositwhich work as follows :

Example : A Term Deposit of Rs. 100000/- under the scheme is treated as a Term Deposit,which comprises of 100 units of Rs.1000/. When a customer needs to withdraw some amount,he is allowed to do so in units of Rs. 1000/-. Only the number of units, which are withdrawn,will invite the penalty clauses. On the remaining amount the customer will continue to earninterest as usual.

• The different schemes under Term deposits are –

! Fixed Deposits (Monthly Interest, Quarterly interest, Half-Yearly Interest, Yearly Interest,Cumulative)

! Recurring Deposits! Flexi-Term Deposits

The distinction between these schemes is mainly w.r.t. the following –

! Deposit in Lump sum / Installments - The deposit amount may be paid by the customer inone lump sum, or in multiple installments at periodic intervals. When the amount is paid inmultiple installments periodically, the deposit is called a Recurring Deposit.

! Interest payable periodically / on maturity! Frequency of Interest payment



Flexi-Term Deposit is of a slightly different nature and is elaborated later in this section.

• The interest offered by the banks on Term deposits will be higher than that ofDemand deposits (Savings Bank Deposit)

Since these deposits are for a fixed duration, banks can effectively deploy such fundselsewhere in the market where the returns will be high. Hence the interest offered on Timedeposits will be higher than the interest offered on Demand deposits. Banks revise interestterm from time to time as per market conditions.

The interest on deposits may be computed as Simple interest or compounding interest and thecompounding can be on Quarterly, Half yearly or yearly basis. Also, the interest can be paidout on monthly, Quarterly, Half-yearly or Yearly basis or on might be cumulated and paid onmaturity.

On a deposit of a certain amount for a specified period, the total interest payment must besame for all the schemes. However, the frequency of interest payment varies betweendifferent schemes. In order to ensure that the total interest paid is same for all the schemes,the following strategy is adopted:

! If interest payable to a customer is retained with the bank (as in the case of CumulativeDeposit Scheme) where interest is paid only upon maturity of the account), then the bankpays interest on the interest retained with the bank. This is referred to as compounding ofinterest.

! The frequency at which interest is compounded affects the total interest paid to anaccount. An account for which the interest is compounded monthly will end up gettingmore interest than an account for which interest is compounded quarterly. In order to avoidthis disparity, as a standard practice interest is compounded quarterly.

! Under the Monthly Income Scheme interest is paid every month. We saw earlier thatinterest is to be compounded quarterly. By reinvesting the interest that is liquidatedmonthly under the Monthly Income Scheme, the customer can effectively earn a higherinterest. To discount for this factor, the interest paid to the customer monthly, will becalculated at rate slightly lower than the actual interest rate.

• Preferential interest rates

Preferential Interest rates (usually 1% extra) will be paid on deposits made by staff of thebank.

Another scheme, which is very popular these days, is for Senior Citizens who are above theage of 60. These customers are given extra (1/2 percent / 1 percent) interest rate andencouraged to keep deposits at the bank.

• In case of premature withdrawal, interest is paid at reduced rate

Withdrawal of the deposit before maturity is referred to as “Premature Closure” or“Foreclosure”. If a customer decides to foreclose the account, then the interest rate applicablewill be 1% less than the interest rate applicable for the reduced period, on the date the accountwas opened.

The interest for the period from the date of account opening till date, will be recomputed at thereduced interest rate, and the adjustment after taking into account the interest already paid,will be credited / debited to the account.

Suppose that a deposit of Rs 10000/ was placed with the bank for a period of 1 year, with theinterest rate being 10%. If the customer decides to close the account after completing just 3



months, then the interest rate applicable will be usually 1% (penal interest) less than theinterest rate applicable for 3 months, on the day when the account was opened. If the interestrate applicable for a deposit for a period of 3 months was 9%, then the effective interest ratefor the account will be 8%.

• Interest Accrual and Application

We shall understand these two concepts through an example.

Example

Suppose that a deposit account is opened with the following details :

Deposit Amount = Rs. 10000Account Opening Date = 15.01.2002Deposit Term = 1 yearInterest Rate = 9%Interest will be paid at the end of each quarter.

For such an account interest will be due for payment on 31.03.2002, 30.06.2002, 30.09.2002,31.12.2002 and upon maturity i.e. on 15.01.2003.

The crediting of interest on the dates mentioned above is referred to as Interest Application.

The effect of interest application in the General Ledger will be,Dr Interest Paid on Term Deposit (Expense A/c.)Cr. Term Deposit A/c. (Liability A/c.)

The interest paid on term deposits constitutes a major portion of the bank’s operationalexpense, and the bank management would want to keep a closer watch on these figures. Ifinterest application is done at the end of each quarter, then the effect of the interest paid onTerm Deposit in the bank’s General Ledger (and also in the ‘Profit & Loss Statement’) will beseen only at the end of each quarter. As mentioned above the bank management may likethese figures to be reflected in the General Ledger earlier.

This is achieved by having an intermediate operation called Interest Accrual, which is carriedout at the end of each month. At the time of interest accrual, the interest for the month iscalculated and accrued to the account. The interest accrual does not constitute crediting ofinterest to the account. The interest accrued is not available for withdrawal by the customer.

The effect of interest accrual in the General Ledger will be,Dr Interest Paid on Term Deposit (Expense A/C)Cr. Provision for Interest Payable on Term Deposit (Liability A/C)

If General Ledger entries are generated at the time of interest accrual, then the GeneralLedger entries to be generated at the time of interest application will be,Dr Provision for Interest Payable on Term Deposit (Liability A/C)Cr. Term Deposit A/C (Liability A/C)

• Maturity Processing

The customer may give the instruction for the renewal on the date of maturity or any futuredate. In either case the renewed account will be opened as on the maturity date of the originaldeposit. The interest rate applicable will also be as on the date of maturity of the originaldeposit. However, the new deposit term should be such that, the new maturity date isgreater than the date of renewal.

Renewal after the date of maturity of the original deposit is referred to as retrospectiverenewal.



The customer can ask for one the following options on maturity -

! Renew the deposit – either principal and interest or principal only! Part Renewal – renew partial amount of the deposit! Renew with additional value – renew the deposit and add some additional amount in

addition to the original principal

All the above options of renewal can be for a term as decided by the customer

! Total Repayment - this includes both the principal amount and the interest component.Bank can pay this either by means of a Pay Order or Credit the customer’s other accountlike Savings/Current if any.

The customer has to indicate his instruction on the back of the FDR/TDR (Fixed/Term DepositReceipt – issued by the bank for a particular deposit) and hand it over to the bank forprocessing on the maturity of the deposit.

• Maintenance of Lien Details

A customer may take a loan against a Term Deposit. When a loan is sanctioned against aTerm Deposit, the Term Deposit is to be marked as a ‘lien’ so that it may not be withdrawn orrenewed. The Term Deposit cannot be withdrawn until the loan is repaid or the lien isremoved.

• Opening of a Term deposit account

A customer wishing to open a Term deposit account has to approach the officer concernedand submit the account opening form duly filled, the specimen signature card andphotographs. The account opening form will have information related to the personal details ofthe customers, the mode of operation, the deposit amount, the scheme under which thedeposit is being made and the duration of the deposit.

The Mode of Operation of the account is to be specified by the customer in the AccountOpening form. The Mode of Operation for a Deposit Current Account may be specified asSELF, EITHER OR SURVIVOR, AUTHORISED SIGNATORIES etc.

The account opening process is very much similar to opening a saving bank account. Thecustomer has to deposit money into this account and this can be by way of Cash, Cheque orTransfer of fund from another account.

If the deposit is being made by cash, the procedure for cash deposit has to be followed.

If the deposit is being made by Cheque, then the customer can hand-over the Cheque to theofficer. The receipt is issued after the Cheque has been cleared and the date of deposit is thetaken as the date on which the Cheque was cleared.

In case of transfer the branch personnel will raise the transfer voucher to debit the otheraccount, and credit the deposit account.

The details of the deposit will be entered in the Deposit Ledger. Separate Ledgers aremaintained for each scheme.

The bank issues a receipt called as the “Fixed Deposit Receipt (FDR)” to the customer, whichspecifies the following –! Deposit number (FDR Number)! Customer or Account number! Name of the deposit holder (joint names if any) and address



! Details of deposit like deposit amount, period of deposit, interest rate, interest type (simpleor compound), date of deposit, maturity date, maturity amount, mode of operation,

At the end of the contracted term of deposit, the deposit is termed to have “Matured”. Thecustomer will have to produce the receipt to withdraw the deposit.

Entries will be made in a diary maintained by the bank. This diary will have details of periodicinterest payments / maturity date-wise.

• Periodic Interest Payments

The bank branch maintains a diary to keep track of periodic interest payments to be made tovarious accounts. The Deposit Ledger will have a page maintained for each deposit account.The top portion of the ledger book page will have details of the interest amount to be paidperiodically and the mode of payment. In case the mode of payment is transfer to otheraccount or payment through issue of DD/MT/PO, then the bank personnel will raise thevouchers for executing the transfer. In case of cash payment, the payment will be made whenthe customer comes to the branch to collect it.

2.1 Fixed / Term Deposits

The customer places a fixed amount for a fixed term (period or duration) with the bank. Theterm could range from a minimum of 15 days to a maximum of 10 years. The deposit for aperiod of 15 – 180 days is termed as short-term deposit.

The interest paid could be of type Simple or Compound, applicable at Quarterly, Half-yearly orYearly basis. Interest can be paid on monthly, quarterly, half-yearly, yearly or can becumulated and paid on maturity.

Such interest may either be paid to customer by way of a pay-order or maybe credited to hissavings/current account with the bank or maybe compounded. The customer indicates hischoice of interest payment at the time of opening of deposit account.

2.1.1 On Maturity

A fixed deposit becomes due for payment on the working day following the expiry of thespecified period of deposit. The customer will have to surrender the receipt issued at the timeof account opening, and the payment will be made only after authenticating the receipt. Onmaturity of the fixed deposit, the bank will repay the amount alongwith accumulated interest tothe customer. If the maturity date happens to be a holiday or Sunday, banks pay interest at theoriginally contracted rate on the deposit amount for such holiday/non-business working dayswhich fall between the date of maturity and the date of payment on the succeeding workingday.

If the customer does not approach the bank immediately on the maturity of the deposit, bankwill transfer the deposit amount (including the interest component) to a separate accountcalled “Unclaimed Deposits”. When the customer comes for repayment, the money istransferred back from the unclaimed deposits and paid to the customer.

If the customer requests for renewal of his deposit, banks can pay interest for overdue periodon such deposits provided –

• The deposit is renewed with back value, i.e.- with effect from date of maturity• The rate of interest for the period it is renewed will be the rate that was prevailing on the

maturity of deposit.• The period for which the deposit is renewed should be more that the back value (lapsed)

period



2.1.2 Pre-Payment (Breaking of Deposit or Foreclosure)

If the customer approaches for a pre-payment, bank had to first calculate rate for which thedeposit was held with it. On arriving at the rate, a penalty rate of 1% was deducted from thearrived rate to compute the interest portion.

For example if a customer places a term deposit with the bank of Rs.10,000 for a period of oneyear at rate of 10% p.a. Incase he approaches the bank after 6 months for prematurewithdrawal of the deposit, the bank will first check the rate prevailing for 6 months when thedeposit was originally booked. Consider the rate prevailing was 9% for a 6-month deposit. Thebank will now pay the customer, interest at the rate of 8% (9% actual rate - 1% penalty rate)on the original contracted amount for period of 6 months.

2.1.3 Interest Calculation

The interest calculation will vary for different types of deposits, namely Domestic and ForeignCurrency.

2.1.3.1 Normal (365 days a year)

If the term of the deposit is specified as days (40 days), then the interest is payable on theprinciple of Actual/Actual basis. If a deposit for Rs. 10000 is placed for a period of 40 days at6% interest, then the interest calculated will be as follows -

Interest = Rs. 10000 * (6 / 100) * (40 / 365)

2.1.3.2 FCNR (360 days a year)

This method of interest calculation is applicable for FCNR deposits only.

If a deposit for USD 10000 is placed for a period of 6 months at 7% interest, then the simpleinterest will be calculated on a monthly basis and will be as follows -

Interest / month = USD 10000 * (7 / 100) * (30 / 360)

This interest calculated will be done every month for the 6 months.

Note - In the case of FCNR (Foreign Currency Non-Resident Account) deposits where thedeposits are maintained in foreign currency barring GBP, period is taken on 360 days basis forthe purpose of interest calculation. For GBP, the basis of calculation is same as normaldeposits of INR.

Examples

Consider a customer who has deposited Rs.10,000 in a bank as term deposit for a period ofone year on January 1. Let us consider the prevailing rates of interest for deposits with variousmaturity as under -

Period Interest Rate (%)15 –30 days 7.0030 – 45 days 7.5046 – 90 days 8.0091 – 180 days 8.50

181 days - < 1 year 9.001 year - < 2 years 10.002 years and above 10.50



Since the customer has placed the term deposit with the bank for a period of 1 year, he willearn 10.00 percent interest on his deposit.

Now let us calculate interest on the deposit for two different cases –

Case I – When the deposit is kept for a period of 1 year

Let us assume that the interest is compounded quarterly.

Month PrincipalAmount (Rs.)

Interest (Rs.) Total Amount (Rs.)

January 1 10,000 Nil 10,000April 1 10,000 250 10,250July 1 10,250 256.25 10,506.25

October 1 10,506.25 262.66 10,768.91January 1 (next

year)10,768.91 269.22 11,038.13

The interest is added to principal amount every quarter and this becomes the new principalamount for calculation of interest for next quarter.

Thus the customer will get an amount of Rs.11,038.13 on maturity.

Note - Incase if there is no compounding of interest, the same will be paid to the customer byway of a pay order/credit to savings account.

Case II – When there is a premature withdrawal of deposit after 7 months

Now the customer after 7 months approaches the bank and requests for withdrawal of deposit.Since he has not completed the requisite time period for which the deposit was placed with thebank, he will attract penal interest. Since the compounding period is quarterly and the deposithas run for 2 quarters and 1 month, interest will be compounded for 6 months and simpleinterest paid for rest 1 month.

Now 7 months will fall in the period 180 days – < 1 year and hence the rate prevailing at thetime when deposit was originally booked was 9.00 percent. Since he has requested forpremature withdrawal hence he will attract a penalty rate of 1% on his deposit. Hence he willget a interest of 8% (9% actual rate – 1% penalty rate) on his deposit for 7 months.



January 1 10,000February 1 10,000

March 1 10,000April 1 10,000 200.00

(10000*0.08*(3/12))

10200.00

May 1 10,000June 1 10,000July 1 10,000 204.00

(10000*0.085*(3/12))+

(200*0.08*(3/12))

10404.00

August 1 10,000 69.36

(10000*0.08*(1/12))+

((200+204)*0.08*(1/12))

10473.36



Thus he will get Rs.10,473.36 at premature withdrawal.

Case III – When the deposit is kept for a period of 5 months

The rate of interest applicable here will be 8.50%



January 1 10,000February 1 10,000

March 1 10,000April 1 10,000 212.50

(10000*0.085*(3/12))

10212.50

May 1 10,000June 1 10,000 144.68

(10000*0.085*(2/12))+

(212.50 *0.085*(2/12))

10357.18

Thus he will get Rs.10,357.18 on maturity.

RBI has authorized banks not to charge any penalty on deposits, which are prematurelyclosed to be re-invested immediately in another term deposit for a longer maturity than theremaining period of original deposit.

2.1.4 Loan against Deposits

Customers can avail loan against the term deposits kept at the bank. The total amount of loanwould be 75% of Principal & Interest amount and the rate of interest on loan would be 2%more than the deposit rate. Customer seeking loan against deposit approaches bank with thereceipt, which is to be discharged (signed by the depositor in favour of bank), to be encashed /appropriated towards loan, in case the loan is not re-paid in full.

2.1.5 Mode of Operation

Fixed deposits can be issued in the joint names of two or more persons. This deposit ispayable to either of them or the survivor on maturity only. There are some points, which needto be taken into consideration while dealing with such deposits. First if one of the depositor’srequests for closure of deposit before its maturity, then the consent of both/all depositors is amust for closure. Secondly if a loan is to be availed against such a deposit, the applicationneeds to be signed by all the depositors. If the deposit receipt is misplaced and a request ismade to issue for a duplicate one, request for it should be signed by all the depositors.

Since the fixed deposit receipt is not transferable and non-negotiable, no other person canclaim money even if he produces original receipt. In the eventuality of a customer approachingthe bank for issue of duplicate receipt, banks should obtain following documents before issuinghim duplicate receipt –

• A request letter from depositor/depositors indicating loss of deposit receipt• A duly stamped letter of indemnity signed by the depositor/depositors as safeguards

incase the original receipt is presented for payment.• A notification of the same should be made in the Fixed Deposit Register.

Change in Names or Addition/Deletion of a name from the deposit should be carefully doneafter considering all aspects and also after taking the approval from the otherdepositor/depositors.



It is permitted to split an existing deposit into multiple units of individual deposits provided theperiod and aggregate amount of the deposit remain the same. It is also possible to split thedeposit individually into names of each of the joint-account holders if the deposit is in the joint-name.

Incase of a deceased depositor, banks can pay to the heir/legal representative of a deceaseddepositor, on maturity, the deposit alongwith interest. If the heir approaches bank for apremature withdrawal, banks can make payment without charging any penalty rate.

2.2 Recurring Deposits

This was introduced for small investors to encourage them to open deposits for small amountsat higher rate of interest. The minimum amount for deposit is Rs.5 and it is collected ininstallments. The most important requirement for a customer to open this type of account is tohave a savings/current account at the bank, though not necessary. The interest rates forrecurring deposits (RD) are in-line with those of fixed deposit interest rates and hence thescheme was very attractive. Normally banks book a Standing Order in the system whereby acertain pre-determined amount known as Installment is recovered from the savings account ofthe bank and transferred to recurring deposit account. The interest on these deposits iscompounded quarterly. The accounts are transferable from one branch to another branchwithout any charge.

Depending upon the pre-payment period, penalty is was charged on the rate of interest fordeposit ranging from zero interest for withdrawal before 3 months to 1% penalty rate to bededucted from actual rate if the tenor of deposit exceeded by more than 1 year.

These deposits can be issued in name of individual/joint names/by a guardian in the name ofminor or even by minor. The depositor is given a passbook while during opening the depositand the depositor has to produce it at the bank at the time of monthly deposits and repaymentof amount. Installments for each month should be paid on any day during the month but beforethe last working day of that month while the accumulated amount with interest will be payableafter a month of the last installment.

One of the most important benefit of opening a RD account is that there is no TDS (Taxdeducted at source) to be paid on the interest on these deposits.

2.3 Flexi Deposits

This is basically a combination of a Time and Demand deposit account. The customer gets thebenefit of the interest rate of Time deposits and the flexibility of withdrawal of demanddeposits. Different banks use different terminology for this account. Some the common onesas Quantum Optima (ICICI Bank), Flexi - Deposits, Sweep Accounts, etc.

Generally, the banks specify a minimum opening balance for opening such an account (sayRs. 25,000) of which some proportion (say Rs. 20000) will be placed as Time deposit in pre-defined multiples (of say Rs. 1000) and the remaining amount is placed as a demand depositsay a Savings account. Customer has the option to choose the term of the deposit.

The minimum opening balance, the proportion of amount in the demand and time deposits, themultiples of deposit will vary from bank to bank and scheme to scheme.

If the balance in the Savings account goes beyond a specified limit, then the amountexceeding the limit in specified multiples (say multiples of Rs. 1000) will be transferred into aTime Deposit account. This is termed as “Sweep In”

Similarly, when the balance in the Savings account goes below a specified limit, then a Timedeposit will be broken and transferred into the Savings account to bring its balance back to thespecified level. This is termed as “Sweep Out”.



Customer can specify the Time deposit that should be broken in the event of a Sweep-Out –LIFO or FIFO. Based on this, either the last generated FD will be broken or the earliestgenerated FD will be broken.

The bank expects the customers to maintain the account opening balance as the averagebalance in the account, else the bank might apply a penal interest.

Example

ICICI bank has a Flexi-deposit scheme called as Quantum Optima. A minimum averagebalance of Rs. 25000 is required for opening such an account, of which Rs. 20000 will be intime deposit and Rs. 5000 will be in Demand deposit (Savings/Current).

The minimum balance in a Savings account is Rs. 5000.

Sweep-in is in multiples of Rs. 5000.

Sweep-Out is in multiples of Rs. 1000.

Sweep-In

Balance in SavingsAccount (in Rs.)

Sweep-InAmount (inRs.)

Balance in SBAfter Sweep-In(in Rs.)

Balance in TermDeposit account(in Rs.)

Case 1 5000 0 20000Case 2 5500 0 20000Case 3 9000 0 20000Case 4 10200 5000 5200 25000Case 5 13000 5000 8000 30000Case 6 15100 10000 5100 40000

Sweep-Out

Balance in SavingsAccount (in Rs.)

Sweep-OutAmount (inRs.)

Balance in SBAfter Sweep-Out

Balance in TermDeposit account(in Rs.)

Case 1 5000 0 20000Case 2 4500 1000 5500 19000Case 3 3200 2000 5200 17000Case 4 1050 4000 5050 13000

During Sweep-Out, whatever is the interest applicable on the deposit that is being broken isapplied and transferred to the savings account. This is not reflected in the illustration above.

2.4 Deposit Schemes for Indians Abroad

There is a large population of Indians living abroad, who are in a position to save a goodamount of money. Government of India has realised this potential and are offeringconcessions and incentives for them to remit money to India through the banks. Banks in Indiaare currently offering different types of deposit accounts both in Indian Rupees and foreigncurrencies for the Non Resident Indians.

2.4.1 Rupee Accounts

2.4.1.1 Non-Resident Ordinary (NRO) Account



This is an account maintained in Indian Rupees, that can be opened by a Non-ResidentIndian. Also, when a customer becomes non-resident, his/her resident account should be re-designated as NRO account and maintained separately from resident accounts.

Non-resident accounts can be opened in the names of Overseas corporate Bodies (OCBs).Joint accounts with residents as well as non-residents are permitted.

These accounts can be maintained in any form, i.e. Savings, Current or Term deposits. Banksare free to determine the interest rates on these deposits, as in the case of domestic deposits.

The credits into this account are by means of proceeds of remittances received in anypermitted currency from abroad through normal banking channels or any permitted currencytendered by the account-holder during his temporary visit to India or transfers from rupeeaccounts of non-resident banks.

All inward remittances in foreign exchange will be converted to Indian Rupees at theappropriate buying rate and will result in purchase transactions.

All payments from this account can only be in Indian rupees. These funds do not qualify forremittance outside India. However, the interest earned on these deposits can be repatriable ininstallments with RBI’s approval.Loans/Overdrafts to non-resident account holders may be granted on the security of fixeddeposits held by them subject to usual norms as are applicable to resident accounts.

Income earned is subject to deduction of income tax. This is to be recovered by the bank andremitted to Income Tax authority.

2.4.1.2 Non Resident External (NRE) Account

This is an account maintained in Indian Rupees, that can be opened in the names of Non-Resident Indian staying abroad and for all OCBs.

Unlike NRO accounts, joint accounts with residents are not permitted. All the joint accountholders have to be NRIs.

These accounts can be maintained in any form, i.e. Savings, Current or Term deposits. Banksare free to determine the interest rates on these deposits, as in the case of domestic deposits.

The credits into this account are by means of proceeds of remittances received in anypermitted currency from abroad through normal banking channels or any permitted currencytendered by the account-holder during his temporary visit to India.

All inward remittances in foreign exchange will be converted to Indian Rupees at theappropriate buying rate. The principal and interest earned on this account are freelyrepatriable at the prevailing rate of exchange. The drawback in this is that the principal andinterest is repatriated at the current rate of exchange and hence the exchange risk is borne bythe depositors.

Money in these accounts can also be invested in the units of UTI, N.S.C, Govt. Securities, etc.The incomes earned from these are also repatriable.

Loans/Overdrafts to non-resident account holders may be granted on the security of fixeddeposits held by them subject to usual norms as are applicable to resident accounts.

Balance in and income earned on all NRE accounts is exempted from provisions of Incomeand Wealth tax.

2.4.1.3 Non Resident Non Repatriable (NRNR) Deposit Account



This is an account maintained in Indian Rupees, that can be opened in the names of Non-Resident and OCBs. Joint account s can be held with residents and non-residents.

The sources of fund for this account is only from abroad. The NRNR accounts may be openedwith funds in freely convertible foreign exchange transferred from any country in any approvedmanner or by transfer of funds from NR/FCNR including prematurely closing NRE/FCNRdeposits without application of penalty on interest.

The only type of accounts permitted in this category are Term deposits.

Repatriation of funds lying in this accounts is not permitted under any circumstance. However,the interest accruing on such deposits is eligible for repatriation at current exchange rate.

Loans/Overdrafts to non-resident account holders may be granted on the security of fixeddeposits held by them subject to usual norms as are applicable to resident accounts.Repayment may be from foreign funds, closure of NRNR account or NRO funds.

Income earned is free from income tax.

2.4.2 Foreign Currency Accounts

2.4.2.1 Foreign Currency Non-Resident (FCNR) Accounts

These are accounts that can be opened in the names of NRIs and OCBs and can be openedin these currencies – US Dollars (USD), Great Britan Pounds (GBP), Deutsche Marks (DEM),Japanese Yen (JPY) and Euro. Joint accounts are not permitted with residents, they have tobe with non-residents.

Credits are permissible in these accounts only in convertible foreign exchange. The principaland interest on FCNR accounts are fully repatriable at any time.

Only specified term deposit accounts other than recurring deposits are permitted.

Loans/Overdrafts to non-resident account holders may be granted on the against security ofFCNR deposits. The loan amount may be freely utilised for all local payments as well as for alleligible investments purposes. Repayment may be from foreign funds, closure of FCNRdeposit itself or even funds from NRO accounts.

The balances in FCNR are fully exempt from wealth tax and the income earned is exempt fromIncome tax.

2.5 Tax Considerations

If the total of the interest earned on all the Time deposit accounts (except Recurring deposit) ofa customer exceeds Rs. 5000 in a financial year April-March, then, the bank has to deduct taxfrom the interest that is to be paid to the customer. This is termed as TDS (Tax Deducted atSource). Limit of interest is restricted to all the deposits placed in a particular branch, i.e.deposits in other branches of same or different bank are not clubbed while arriving at eligibilityof TDS.

The tax percentage is 10% for individuals and 15% for corporate. This limit of Rs. 5000 andthe tax percentages are subject to change.

The tax deducted has to be paid to the government. The deduction could be made from thedeposit amount or the same could be recovered from the savings/current account ofcustomers.

In case of joint account in a term deposit, primary holder/person with first name is liable fortaxation for the contracted amount.



3. LOANS AND ADVANCES

In this chapter we shall try to understand the basic details regarding loans and advancesgranted by commercial banks.

3.1 Concepts

One of the major activities of the bank is to lend funds to the borrowers such as traders,business and industrial enterprises. The bank while accepting deposits from the customershas to deploy these funds effectively so that the operation is profitable for the bank. The bankhas to consider various associated costs such as interest to be paid on deposits, staff costswhile deploying these funds so that the return on the funds lent will be more than the bank hasto pay for using the funds.

Thus lending is one of the most effective and profitable means of deployment of the fundsavailable with the bank. The bank earns income by way of interest and discounts on the fundslent. It forms one of the major sources of income for the banks.

Loan is money advanced to a borrower to be repaid at a later date, with interest. Loansaccount form the largest chunk of interest earning asset held by banks. They are broadlyclassified as

! Demand loans - repayable on demand by the bank (to be repaid within 3 years)! Term loans – loans for a specific period (longer repayment period)

Advance is the principal amount available when a borrower draws from a line of credit. It isdrawing against a pre-approved line of credit. Advances can be of two types

! Overdraft! Cash credit

Both of them are running accounts.

Loans and Advances are generally used interchangeably but there is fine degree of differencebetween them. In case of loan accounts no chequebook is given where as it is given in case ofadvance and borrower can with draw/deposit money into his account frequently.

Need for Loans / Advances - Examples

• A person may avail of a Hire-Purchase loan to purchase consumer durable like Washingmachines, TV etc. The loan may be repaid in easy installments over a period of 1 or 2years.

• The cost of purchasing a house in any city will be quite high, and the common man will notbe able to raise such a high amount through savings from his regular income. In order toraise the amount necessary, a person can avail of a loan from commercial banks ororganizations such as HDFC. The amount so raised is may be used only for the purchaseof the house. The loan may be repaid through easy monthly installments over a period ofsay, 10 to 15 years.

• A professional having the technical know-how to start-off a business may avail of a loanfrom commercial banks to finance the initial investment to be made towards building thenecessary infrastructure, procuring raw materials etc.

• An established industrial house may approach a commercial bank to raise funds forfinancing its expansion / diversification plans.

Commonly used Terminology



Tenor – This is the duration of the loan (months or years)

Moratorium – This is additional time given be the bank to the customer (or by any creditor tothe debtor) for repaying the loan (or debt). If the Moratorium is 1 year, then during this initial 1year period the customer need not make any repayments.

The Tenor included the moratorium.

PLR – Prime Lending Rate – This is the lending rate with the least amount of risk, the rate atwhich the institution will lend to its best customer. This is market dependent and can vary frominstitution to institution.

Spread – is the rate charged over the PLR depending on the risk.

Floating Rate – This is equal to PLR + Spread

Tiered Interest Rate – This is the rate applied by sub dividing the amount into ranges or tiersand applying different interest rates to different tiers. For a single loan of 10,00,000 to acustomer, tiered interest could be something like,

upto 5,00,000 @10%5,00,000 – 7,50,000 @11%Above 7,50,000 @12%

Commitment Charge – This is a charge levied by the bank on the customer for not utilizingthe sanctioned loan amount. Consider a case, where the loan sanctioned is for Rs. 1 Croreand the customer has utilized only Rs. 25 Lakh. Though the bank has blocked the sanctionedamount, it is earning interest only on the utilized amount of Rs. 25 lakhs. Hence banks take acommitment charge on the unutilized part of the loan.

Pre-payment penalty – If the customer wants to repay the loan before the due date, bank willimpose a penalty as it has committed the funds for a fixed period, but has lost the interest forthe remaining period.

3.2 Principles for Lending

The bank follows certain principles for lending the funds to various borrowers, which arediscussed below –

• Safety

The bank while assessing the loan requirement of a borrower has to carefully assess thecredentials of the borrower. It has to judge whether the borrower will be able to repay the loanand also service the interest component associated with it. The repayment of loan dependsupon the borrower’s capacity to pay and willingness to pay the loan. Since lending funds is arisk, bank has to take some form of security from the borrower to safeguard itself from the risk.The security is in the form of tangible assets and depending upon the credentials of borrower,bank may also insist to keep additional security in the form of cash margin at the bank.

• Liquidity

The banks extend loan to the customers typically against some form of security. These couldbe in the form of fixed assets like land, building, plant & machinery of goods and commodities,which are easily marketable and liquid in character. The bank will normally lend against thesesecurities since these are easily marketable and the loss associated with it will be minimum.

• Profitability



The banks deploy the funds available with it in the form of advances/loans to the customers.They ensure that the return on the funds deployed will be more than the costs associated withusing these funds. It is at the bank’s discretion to decide the rate at which it can grant anadvance. The rate will be different for different category of customers, viz. – a customer withhigh reputation may be charged a lower rate as compared to some other customers. Theintention should not be to lend to make higher profits at the cost of safety or liquidity.

• The Purpose of the Loan

The bank has to carefully assess the customer’s requirement of loan before actually decidingto disburse the same. They should ensure that the need is genuine and also the intentions andcredentials of the customer are to honestly utilize the facility. The banks ensure safety bygranting loans for productive purposes such as meeting working capital needs of a customer.No loan should be extended for speculative and unproductive purposes such as socialfunctions/ceremonies. Term loans are also granted for capital expenditure for establishingbusiness, which are of long duration.

• The Principle of Diversification by Banks

This is one of the most important principles of lending. The banks will tend to minimize the riskassociated with lending by spreading the loan facility to different category and industries. Itthereby ensures that the impact of slowness/recession does not affect its overall portfolio. Italso ensures that the lending is not restricted to only a few big firms but to individuals andsmall firms also thereby diversifying in risk.

3.3 Types of Loans/Advances

The different types of loans/advances that the bank normally grants are –

• Corporate Loans• Retail Loans

Loans and advances granted to a borrower can also be classified into two categories namely –

• Secured Advance• Unsecured Advance

3.3.1 Corporate Loans

These are generally high on value and low on volume. There is a qualitative analysis backedby a quantitative analysis. These are qualitative loans and are generally granted to big firmsand industrial enterprises. For large corporate loans, the decision-making is centralized at theHead Office level and the management committees at HO take the decision.

The different types of loans under this category are –

• New Projects – These are of high value and of long period and are normally given byFinancial Institutions like IDBI, ICICI, IFCI, SIDBI

• Working Capital – These are normally given by banks.• Upgradation/Expansion – These are normally given by banks in conjunction with financial

institutions.

3.3.1.1 Working Capital Loan

The most common corporate loans dealt by banks are working capital loans. This loan is usedto finance the operating cycle of an organization. Operating Cycle in a typical organization isthe process of investing cash in raw materials, converting them in to finished goods and thenin to receivables through sale and transforming receivables by collection into cash.



The Working capital loans can be classified as –

• Non-Fund Based

Here, there is no parting of funds by the bank. In fact, upon the non-fulfillment of certainobligations/conditions by the customer, the liability comes into picture. Some of the non fundbased advances are –

! Guarantees! Letters of Credit

These have been discussed in detail in the subsequent chapters and also under ForeignTrade Finance.

• Fund-Based Advance

Here, the bank actually gives an advance to the customer by way of loan or assigning somelimit and the customer can then utilize the limit and continue to draw funds and depositwhenever he has idle/surplus funds. The different types of fund based advances are -

! Cash Credit Facility! Overdrafts! Loan Systems! Packing Credit /Pre-Shipment Credit! Post-Shipment Credit! Purchase and discounting of bills

Packing Credit and Post-Shipment Credit are discussed in detail under Foreign TradeFinance.

Cash Credit Facility

These advances are repayable on demand and there is no specific date of repayment but theyroll out over a period of time. Under this facility the bank has to keep sufficient funds with himwhich covers the limits set to various customers but earns interest only on the amount utilizedby the borrower. In order to safeguard against this risk (loss of interest) on the unutilizedfunds, banks normally a charge called ‘Commitment Charge’ on these unutilized funds,which is a nominal charge. The levy of this charge is entirely at the bank’s discretion.

This has been discussed in detail under the section on Cash Credit and Overdraft Account.

Overdrafts

This is a facility wherein a customer is allowed to withdraw from his account more than whatstands to his credit. The security taken maybe a collateral security or a personal security fromthe customer. The customer is allowed to withdraw as and when he needs the funds andrepay it back whenever he has idle/surplus funds with him. Interest is charged on the exactamount overdrawn by customer and for the period of its actual utilization. Such an advance isgranted on the basis of a written application and a promissory note signed by the customerwhich includes the terms and conditions of the facility including rate of interest chargeable onthe facility.

Loans

This facility is extended for a definite purpose and for a pre-determined period. Here the fundsare required for single non-repetitive transactions and are withdrawn only once. These loansare repayable in installments. A fresh request needs to be made each time the borrower needsadditional funds or to renew the existing facility.



The banks grant loans for different periods such as short, medium and long and accordinglyclassified. They are explained below –

Short Term Loans

These loans are granted to meet the short-term requirements or working capital needs of afirm. The security against these loans is tangible assets mainly moving assets such as goodsand commodities, shares, debentures, etc. Banks are permitted to extend loan for anotherperiod at expiry of tenor of first loan.

Term Loans

Medium and Long Term Loans are usually called ‘Term Loans’. These are granted for a periodof more than three years and are usually towards purchase/acquisition of capital assets fornew unit/expansion of existing unit. These are normally granted solely or in conjunction withspecialized financial institutions such as IFCI, ICICI etc., which may be called as projectfinance. These loans are usually secured against tangible assets like land, buildings, plant andmachinery etc. Banks are free to charges fixed/floating rate of interest on these loans, thebase rate being the PLR (Prime Lending Rate). Normally the higher contribution is done byfinancial institutions and hence they will be having first charge while banks will have secondcharge on the security.

Bridge Loans

These are basically short term loans granted to industrial undertakings to meet their urgentand essential needs for the period during which their formalities for availing a term loan fromfinancial institutions are being fulfilled or necessary steps are being taken to raise funds fromcapital market. These loans are granted by banks or financial institutions and are repaid whenthe term loan facility is sanctioned or funds are raised from the capital market.

Composite Loans

These are granted for buying capital assets and working capital purposes and are usuallygranted to small borrowers such as artisans, farmers, small industries etc.

Consumption Loans

These are granted on a limited scale for miscellaneous needs such as educational expenses,marriages. Medical needs etc.

3.3.2 Retail Loans

These are generally low on value and high in volume. These are highly parameterized sincethese are designed to the needs of small companies/individuals. Retail loans are usually givenfor Housing, Vehicle, Education, Consumer items like Refrigerator, etc.

As these loans are for a low value, detailed appraisal is not required and decisions are takenat the branch level. These are usually specific purpose loans with direct payment to thevendor.

The purpose for which the loan is given is generally taken as the Security.

Currently a number of 3rd party agencies are involved in the retail loan cycle. DSA’s (direct sellingagents) are appointed by the bank for marketing and getting additional business. These arebasically agencies with knowledge about the market and also having some contacts. They contactvariety of customers of different segments explaining them about the various schemes of the bank .Currently the focus of all banks is on Retail Business, i.e. both retail deposits and retail loans sincethe risk associated is lesser as compared to corporate customers.



A simplified process / steps is shown below -

1. Application form sourced by Direct Selling Agent (DSA)2. Submit to the bank3. Bank sends details to the verification agency4. Verification agency report sent back to the bank5. Bank sanctions/rejects the loan6. Gives to the processing agency for disbursement and recovery

Type of installments in these type of loans will be mostly EMI (equated monthly installments)

3.3.3 Secured Advance

A secured advance is granted on security of assets, the market value of which is not at anytime less than the amount of such advance. These advances are usually made on security oftangible assets such as goods and commodities, land and buildings, gold and silver, corporateand government securities etc. A charge on any such assets offered, as security must becreated in favor of the banker. If the market value of the security falls below the amount of theloan, the loan is considered as partly secured.

3.3.3.1 Types of Securities

The various types of securities on which a secured advance can be granted are –

! Advances against goods! Advances against Documents of Title to Goods! Advances against Stock Exchange Securities which may include Government Securities

such as National Savings Certificates, Government Promissory Notes, Kisan Vikas Patraand Corporate Securities such as Preference Shares, Debentures

! Advances against Life Insurance Policies! Advances against Real Estate! Advances against Fixed Deposit Receipts! Advances against Book Debts! Advances against Supply Bills! Advances against Gold Ornaments and Jewelry

3.3.3.2 Mode of creating charge on secured advances

Lien

Here the bank retains the security of the borrower while the ownership of the securities restswith the borrower. The bank has the right to sell the securities in certain circumstances. e.g.Fixed Deposits, NSC, etc.

Pledge

It is defined as bailment of goods as security for payment of a debt or performance of apromise. In case of default by the pledeger (borrower) to make payment of the debt, thepledgee (bank) has the right to either file a civil suit against the pledger for the amount dueand retain the goods as a collateral security of to sell the goods pledged after giving thepledger reasonable notice of sale. The physical possession of the security rests with the bank.

Hypothecation

Here an equitable charge is created on the movable goods in favor of the bank. The goodsremain in possession of the borrower who has to deliver the possession of goods to the bank ifthe bank demands so. The charge of hypothecation is thus converted into that of a pledge and



the banker or hypothecatee enjoys the powers and rights of a pledgee. The borrower heremerely acts as an agent of the bank holding possession of the goods.

Mortgage

This type of charge is created whenever a customer offers an immovable property such asland and building as security. Thus mortgage is transfer of an interest in the specificimmovable property for the purpose of securing the payment of money advanced to by way ofa loan. If there are more than one co-owners of an immovable property, every co-owner isentitled to mortgage his share in the property. The actual possession of the property need notbe always transferred to the mortgagee.

The different forms of mortgages are –

! Simple Mortgage! Mortgage by conditional sale! Usufructuary mortgage! English mortgage! Mortgage by deposit of title deeds! Anomalous mortgage

The mortgagee may himself like to ‘Sub-Mortgage’ the property mortgaged to him by themortgagor. Banks in circumstances accept such sub-mortgages when a customer is unable tofurnish any better security to the banker. Banks should take adequate precautions beforeaccepting such security.

Assignment

It is a transfer of a right, property or a debt – existing or future. The borrower may assign anyof his rights, property or debts to the banker to secure a loan from the banker. A borrower mayassign book debts, money due from government department or semi-governmentorganizations, life insurance policies. The different types of assignments are Legal Assignmentand Equitable Assignment.

3.3.3.3 Registration of Charge

Registration of Charge is resorted to in order to prevent issues arising out of customers takingloans from multiple institutions on the basis of the same security. The bank’s interest incompany’s stocks (or any other security) as security needs to be registered with the Registrarof companies (ROC). Here, customer registers a charge on the security on behalf of bank.

Some of the charges can be –

! Sole – Only a single bank will have all the rights! Pari-passu – The charge is proportionately shared between the banks! First- Second – This arises when the company through some financial institution has

already taken a loan against a security. The same is being offered as security forsubsequent loan from some other institution. Then the other institution will have thesecond charge on the security.

3.3.4 Unsecured Advance

These advances are also granted to customers having tangible assets as security, thedifference being no charge is created on any such assets of borrower in favor of the banker.Here the security happens to be personal obligation by borrower, which may sometimes beaccompanied by a guarantee given by a third party regarding repayment of the loan. Thesetypes of advances are generally granted with caution and within certain limits.



3.4 Credit Process in a Bank

3.4.1 Application

A customer wishing to avail of a loan from the bank makes an application with a proposal tothe branch manager. Depending on the nature and size of the loan other support documentslike annual reports, performance reports, etc. will have to be submitted.

Suppose that the bank is financing a customer for setting up a manufacturing plant. If themanufacturing facility gets destroyed due to any natural disaster / accident then the customerwill not be in a position to repay the loan, and the bank will suffer a loss. If the manufacturingplant is insured against such calamities, then the customer will be able to recover his loss fromthe insurance companies.

In order to safeguard its own interests the bank may insist on the customer getting insurancecover.

3.4.2 Appraisal

The Branch appraises the proposal based on the documents submitted and other independentobservations and puts down their recommendation. Depending on the size of the loan, theloan may be sanctioned by the branch itself, or it may require a sanction from the Zonal Office/ Head Office. For large loans, the bank will have to do a detailed credit appraisal beforesanctioning the loan. Appraisal is the written estimate of market value by a qualified appraiser.

Appraisal of a loan application is for –

• Assessing the credit-worthiness & loan requirements of the borrower• Loan repayment & interest servicing capacity of the borrower• Risk profile of the borrower• Evaluation of security offered/required. The evaluation of the security is done on Liquidity,

Marketability and Tangibility. In most cases, the security has only a notional value and may notremunerate as much at the time of recovery / liquidation.

• Value of the overall relationship to the bank

Also, in such cases the decision to sanction / reject the loan will be taken centrally at the HO.

The branch will forward the loan application, the supporting documentation and itsrecommendation to the RO/ZO.

The ZO / HO will scrutinize the proposal and the related documents. If satisfied, the papers aresent to the HO for final approval/decision. Else, they are rejected and sent back to the branch.Finally, the loan is approved or rejected at the HO and the papers come back to the branch.

Based on the securities submitted by the customer, the bank will compute the drawing power.The drawing power is the amount upto which disbursement may be made for a LOAN account.

3.4.3 Sanction / Disbursement

Once the loan is sanctioned the bank will inform the customer. The loan will be disbursed afterthe customer has signed the loan agreement specifying the terms of the loan includingprocessing charges, interest rates, payment terms etc. A loan account is opened for thecustomer in the appropriate ledger.

At the time of disbursement, the processing charges are debited to the loan account. Thedisbursement may be made by cash, Cheque or transfer depending on the type of the loan asper the guidelines issued.



In the case of certain types of loan, disbursement may not be made by cash. Also in somecases, the Cheque may be issued in the name of a third party only. As an example, in thecase of a housing loan the Cheque will be issued in favour of the builder. This is to ensure thatthe funds are used only for the purpose stated in the application.

The loan agreement would specify the terms applicable like interest rate, mode of repayment,repayment schedule, penal charges, processing charges and other clauses applicable.

3.4.4 Repayment

Repayment of loan may be made by cash, Cheque or transfer from any other account of thecustomer. Repayment of the loan by the customer could be free format or as per therepayment schedule specified in the loan agreement. The repayment schedule would specifythe frequency and the dates for payment of the loan installments and the installment amount.

3.4.4.1 Priority Sequence for Apportionment of Repayment

The outstanding balance in case of loan accounts can be broken up into the! Outstanding Principal! Outstanding Interest! Outstanding Overdue Interest! Outstanding Charges.

Any repayment will be apportioned towards these components. In case interest is notcompounded, the interest will be charged only on the outstanding principal. If the repaymentamount is apportioned towards the principal first, and then towards the interest then thecustomer benefits, since the interest will be charged to him on a reduced amount. On the otherhand if the interest is recovered first, then the bank benefits.

Since the sequence in which the interest is apportioned affects the interest charged to a loanaccount, it is very important to specify clearly the sequence in which the repayment amount isto be apportioned towards the various components. This is called as the Priority Sequence forApportionment of Repayment.

The possible combinations can be PIC, PCI, IPC, ICP, CPI, CIP whereP - PrincipalI - InterestC - Charges

If the sequence for apportionment is PIC, then the payment is first apportioned towardsPrincipal, then towards the Interest and finally towards the charges. The interpretation for theother values will be similar.

3.4.4.2 Installment Schedule

The installment schedule itself could be set up if different ways. The common ways for arrivingat the installment schedule are as follows :

• Equal Installments of Principal

The installment amount will have the principal component only, and will be equal to the loanamount divided by the number of installments. The interest is charged on the outstandingbalance on quarterly/half-yearly/yearly basis, as per terms agreed upon at the time of sanction

• Equated installments of Principal and Interest

The installment amount will have the principal and interest component. The installment amountpaid periodically will be utilized to recover part of the principal as well as the interestoutstanding. The monthly installment amount computed will be such that when the last



installment is paid, the principal as well as the interest outstanding will become 0. This issubject to the condition that the installments are all paid as per the schedule. If the pattern ofpayment of the installment changes, then the interest computed and consequently theinstallment amount will also change.

• Free Format or User Specified Installment Schedule

In case of free format loans, the customer can make payments according to his convenience.However, whenever the customer makes a payment, the interest till that date is charged to theaccount, and recovered from the amount repaid. Only the amount left over will be used forrecovering the principal. The customer in turn can make the payment towards the interest aswell.

3.4.4.3 Interest Calculation

Interest is charged on the outstanding balance in the loan account. Interest is computed basedon the daily debit products similar to CC/OD accounts. Interest is not paid on the creditbalance (due to excess payments), in the loan account. Interest is charged to the account atthe end of each quarter of the financial year. In the case of free format loans, interest ischarged whenever the customer makes any payment.

Thus to summarize,

Upon disbursement, the loan account is debited by the loan amount, and the loan account willhave a debit balance equivalent to the sum of the loan amount and the processing charges.

Interest will be computed based on the debit balance on a daily basis and charged to the loanaccount at the end of each quarter, or at the time of payment in case of ‘Free Format Loans’.

The balance will become 0 at the end of the loan term after the loan amount, the interestcharged and the other charges are recovered from the repayments made in installments.

3.4.5 Post Sanction

There will be a post sanction monitoring process to access the status of loan.

• Stock Statements – The customer has to send his monthly stock statements to the bank;mandatory for all cash credit and loan account

• Quarterly Information System (QIS) – I, II & III – required to be submitted for by customers withaccounts enjoying large facilities viz. 50,00,000 and above. This limit varies from time to time.

QIS-I is the statement giving estimates of production, sales, stock position and currentliabilities. It should be submitted in the week preceding the beginning of the quarter the firstquarter

QIS-II is the statement showing actual performance in the quarter. It should be submitted within six weeks from the end of quarter.

QIS-III is basically the balance sheet .It is the half-yearly projection.

On the basis of these statements, the banks are required to prepare the quarterly review ofaccounts .If the customers fail to submit any of these statements in time he will be penalized.

• Stock verification by a chartered accountant

• Periodical inspections

• Conduct of account – Credit/debit summations, Cheque issued/returned, cash turnover in theaccount, timely retirement of Bills/LCs

• Regular statutory / MIS reporting



3.5 Banking Arrangement

There are many corporate requirements for advances and loans, which cannot be serviced bya single bank due to the value of the loan. The different type of banking arrangements thatmay come into play in such situations for securing loans and advances are –

3.5.1 Consortium Advances

This type of advance is also referred to as ‘Participation Financing’ or ‘Joint Financing’. Heretwo or more banks jointly in proportion of their capacities meet the credit needs of a borrower.The main reason for such a advance that any individual bank may not be independently ableto meet the credit needs of the borrower and also may not be ready to bear alone the riskassociated with such and advance incase it is a large advance. Banks now not only grant suchadvances for working capital requirements of a customer but also grant advances for termloans in association with financial institutions. The security is common for all the participantbanks and is charged to all the banks for the total advance. Usually one bank acts aconsortium leader or a lead bank and takes the lead in the processing of loan proposal, itsdocumentation, recovery, etc. The participating banks enter into an agreement setting out theterms and conditions of such participation agreement. Here periodic meetings are heldbetween member banks and there is an exchange of information. The charge here is sharedproportionately between all the banks depending upon their share in the consortium advance.This is terms as ‘Pari-Passu Charge’.

3.5.2 Multiple Banking Arrangement

Here a customer is having banking arrangements with multiple banks. The main differencebetween multiple banking arrangement and consortium is that whereas there is a lead bank inthe consortium, there is no such lead bank here. Infact all the banks operate independentlywithout exchanging any information and level of advance is irrespective of knowledge of suchfacility by any other member banks.

3.5.3 Sole Banking Arrangement

Here customer is dealing with only one bank and hence all the security will be placed with onlybank. Thus only one bank has total exposure for that customer.

3.5.4 Syndicated Loans

Two or more institutions agreeing to provide a credit facility using a common document. Although itis very similar to consortium lending in terms of risk sharing the borrower is free to have competitivepricing and is not bound by a fixed repayment period under syndicate credit.

3.6 Factors Limiting Level of Bank’s Advances

The various factors that determine the level of advances sanctioned by a banker are as under-

• The Size and Maturitywise Pattern of Deposits

It is one of the most important aspects when deciding upon the level of advances. As yourdeposit size increases so are the available funds and so the advances level. In case of largenumber of demand deposits, the liquidity associated will be high and hence the level ofadvances will be low or the advances should also be of short duration whereas incase of largenumber of time deposits, banks have the funds available with them for a certain period andhence can lend the funds effectively for longer periods.

• Credit Control by Reserve Bank



The capacity of banks to provide loans depends upon its cash resources. The cash resourcesincrease with increase in deposit size, borrowing from RBI, sale of investments. The RBIcontrols these factors by making several policies, which it feels for expansion of creditfacilities.

• Seasonal Variation in Bank Credit

An agricultural country like India has a seasonal variation in demand for credit. The seasonmay be divided into a busy season and a slack season. The busy season is normally for theperiod November to April when there is a higher demand for advance largely to finance themarketing and distribution of agricultural crops whereas slack season is for the period May toOctober when there is inflow of funds in banking system as a result of liquidation of stocks ofagricultural produce.

• The Demand for Credit

The rise and fall in credit depends on demand of bank credit by borrowers. This is againdependent on a variety of factors such as

! The level of production! The level of inventories held! The price level of goods and commodities in the country! The procurement policy of Food Corporation of India and other state agencies

3.7 Classification of Advances and Provision for Non-Performing Assets

Banks must take utmost care while sanctioning loans to ensure that the loans will be repaid.However, despite all precautions a certain portion of the loans does turn out bad. However, itis the endeavor of all banks to keep the percentage of bad debts as low as possible. Thissingle factor has severe repercussions on the performance of the bank.

Banks have to classify the health of the loan accounts periodically and make appropriateprovision in the Balance Sheet to reflect a true picture of the financial position. While the banksmay pursue in trying to recover the loan, adequate provision has to be made in the balancesheet.

RBI introduced new norms for classification of non-performing assets and making provision forthese in the Balance Sheet. The new norms were based on the number of outstandinginstallments. After the new norms were introduced, banks which were hitherto reporting profitshad to make large provisions for the bad debts, and as a result only 4 nationalized banksreported net profit for the financial year 92-93.

The advances can be classified as

• Performing

These are standard assets, i.e. loans and advances, which are earning interest and part ofprincipal regularly.

• Non Performing

These are the loans and advances that is not paying principal and interest according to theoriginal terms of the borrower’s loan agreement

These non-performing assets can be further classified as

Sub-standard - These are characterized by the distinct possibility that the lender will sustainsome loss if the deficiencies are not corrected. Some loss of the interest component hasalready occurred or anticipated but the loss of principal is considered unlikely.



Doubtful – These are Loans in which full repayment is considered uncertain. A loan classifiedas doubtful will have all the characteristics of sub-standard loan with the added characteristicthat credit weaknesses make full collection or liquidation highly questionable and improbable.

Loss – These are Loan written off as uncollectable and assigned to the workout committee if itis a commercial loan.

RBI policy defines the classification of assets and the amount of provisioning every bank isrequired to maintain

3.8 DICGC Guarantee for Small Loans

Deposit Insurance and Credit Guarantee Corporation (DICGC) has been established by RBI toprovide insurance to banks against bad debts and also to the depositor. In the event of acustomer not being able to repay the loan, the bank can make an insurance claim to DICGC.The bank has to pay insurance premium to the tune of 1.5% of the outstanding loan amountunder the loan schemes for which DICGC cover is available. The premium has to be paid toDICGC annually.

In fact the commercial banks do not have a choice. For the valid loan schemes, the bankshave to obtain DICGC cover as per RBI ruling. The insurance premium amounting to 1.5% ofthe loan amount is to be borne by the bank. However, for some of the schemes the banks inturn collect the premium amount from the customer.

In the event of a loan going bad, the bank will make a claim to DICGC. The claim will besettled by DICGC through Cheque / pay-order.

Export Credit Guarantee Corporation (ECGC) gives insurance cover to banks against exportcredit like pre-shipment/post-shipment credit.

3.9 Procedures for maintenance of Loan Accounts

The procedure followed for processing financial transactions for Loans accounts is identical toprocedure followed for CC/OD accounts. The main differences are explained below:

! Unlike CC/OD accounts, loan accounts are not running accounts. Once the disbursementhas been made, there can be no further debit to the loan account except for charginginterest and other service charges. For an account functioning normally, the onlytransactions that will take place will be the periodic repayments of the loan as per therepayment schedule. The repayment could be through cash, Cheque deposit or transfer.The procedure followed for processing of these transactions will also be as in the case ofCC/OD account.

The loan account, however, can be debited in other circumstances also wherein there aremultiple disbursements. Depending upon the customer’s requirements, it may so happenthat a loan could be disbursed in 2 or more installments. In that case a limit is set to thesanctioned amount and multiple disbursements are allowed at pre-defined period asrequired by the project. This, however, does not affect interest application anywaybecause interest is charged on the outstanding balance from day one.

! The outstanding balance for loan accounts are bifurcated into principal, interest, andcharges, since a loan account is not a running account. When the customer makes arepayment, the amount has to be apportioned towards principal, interest and charges in aspecified order. If the interest is not to be compounded (i.e. interest is not be charged onthe outstanding interest), then it will be beneficial to the bank to recover the interestoutstanding first, and only then recover the principal.



! Claims made to DICGC may be remitted to the branch by Cheque. These payments haveto be treated differently.

! DICGC insurance premium is paid annually. Under certain schemes the premium will bedebited to the loan account, and recovered from the customer.

! A considerable portion of the effort is spent by the branch personnel, to compile theinformation for the reports to be submitted to the management and to RBI. The data forthese reports have to be compiled by going through all the ledgers and computing thetotals.

3.10 Closing of Loan Accounts

A loan account can be closed after the entire outstanding balance including principal, interestand charges has been settled by the customer. However, unlike a CC/OD account thecustomer cannot settle his account at any time he wishes. Settlement of the loan atleast forthe large loans has to be as per the repayment schedule. A request has to be made to thebank branch in case the customer wishes to make an early settlement or restructuring of theloan repayment.

3.11 MIS & Statutory Reporting to RBI

Loans and Advances constitute a major portion of the banks’ business, and interest earned onloans and advances forms the major source of income for the banks. Thus details of theperformance of the loan accounts provide crucial pointers to the performance of the bank as awhole.

Hence the bank management would be mainly interested in the figures relating to loans andadvances for monitoring the performance.

As per RBI guidelines banks have to adhere to certain targets set for priority sector lending.Banks have to send reports in specified formats periodically to RBI, to help the latter to monitorand compile consolidated statistics. Standard codes for categorization of loans based onindustrial sector, region, occupation of the customer etc. have been specified by RBI.

Banks should sanction loans to some areas of customers and they will be given subsidies by thegovernment for this. These areas include –

Priority Sector - A fixed percentage of the advances of a bank should be lent to certain sectorsidentified as priority sectors like SSI, village & khadi, handicrafts, housing etc.

Special Govt. schemes - Also, some portion of the advances should be towards specialgovernment schemes like Kisan Vikas Yojna, Jawahar Vyapar Yojna etc.

Under certain Govt. sponsored loan schemes, a certain amount of subsidy is provided by the Govt.towards repayment of the loan. The bank after issuing the loan to the customer, will make a claim tothe appropriate Govt. agency for the Subsidy / Refinancing

Deposit insurance & credit guarantee corporation (DICGC) extends insurance cover to banksfor the credit advanced by them and the deposits taken by them

The bank branches hence have to compile the statistics and send reports periodically in thespecified formats to the Zonal Office / Head Office.

3.12 Deficiencies / Limitations of the manual system

The activities involved in the processing of loan application includes validation of theapplication and the documents submitted, appraising the client and the application,sanctioning the loan, preparation and signing of the loan agreement and disbursement of the



loan. After these activities are performed, for normal accounts the only customer transactionthat will take place will be the periodic repayments. Effectively there may be just one customertransaction per month. Hence the major effort spent in the maintenance of the loan accountsshould be only upto this stage.

However, in practice because of the inherent limitations of dealing with papers, considerabletime is spent by the bank personnel in compiling MIS and Statutory reporting, sending outreminders to the customers, Identifying and Classifying bad loans, computation and chargingof interest, computation and charging of DICGC insurance premium annually etc.

Thus the cost of maintaining loan accounts increases, thereby reducing the profitability.

Also since the branch personnel are saddled with the paper work, recovery of loans which isan important function suffers.



4. BILLS

4.1 Concepts

In this section the basic definitions, rules governing the Purchasing, Discounting andCollection of Bills / Cheques will be discussed.

Let us first consider an illustration to understand the business practices followed in a typicaltrade transaction.

Illustration :

Suppose that a company in Bombay (Supplier) has negotiated with a company in Calcutta(Buyer) to supply certain goods. The transaction involves supply of goods by the Supplier tothe Buyer, and payment of the agreed amount by the Buyer to the Supplier. The procedureusually followed for executing this transaction would be as given below.

• The Supplier will arrange to despatch the goods by road / rail and obtain a MotorTransport Receipt (MTR) / Railway Receipt (RR) from the agent transporting the goods.The MTR / RR gives title of the goods to the party mentioned in the MTR / RR i.e. theBuyer and this is called as the “Documents of title to goods”.

• The Supplier will raise an Invoice asking the Buyer to make the payment.

• The Supplier will hand over the MTR / RR to the Buyer after receiving payment. TheTransport agent will hand over the goods to the Buyer against the MTR / RR.

Alternately, the Supplier hands over the MTR / RR to the buyer. Based on this the buyertakes possession of the goods from the transporter and then makes the payment to thesupplier.

In the procedure above, there are few uncertainties and either party will not be prepared totake risks and safeguard their own interests. This is where the concept of Bills of Exchangeoriginates and also the role that a bank plays in this.

So in order to recover the sale proceeds from the buyer, the seller draws a Bill of Exchangedirecting the buyer to pay to a named person the amount thereof. The goods are thendespatched and the seller obtains the receipt of dispatch (Document to the title of goods). Theseller also makes out an invoice representing the cost of the goods sold. Thus the seller

• Draws a bill of exchange• Takes out the documents to the title of goods• Makes out an invoice

Role of Banks

In case the Supplier and the Buyer are located in the same city, the supply of the goods andthe corresponding payment can take place simultaneously. However, handing over the MTR /RR, and collecting the payment physically for each transaction is not practical for the Supplier,since very often the Buyer may be located in a different city.

It is here that Banks play the role of an intermediary i.e. agent for collecting the salesproceeds. The bank offers their Collection services whereby the bank undertakes to collectthe payment on behalf of the supplier and remit it back to the supplier. Banks make use oftheir network of branches to carry out this function. The bank will earn income in the form ofcommission for the collection service.

The procedure followed by banks for collection of bills will be as explained below.



• The Supplier in Bombay will arrange to dispatch the goods to Calcutta through a TransportAgency. The agent will issue a MTR / RR to the Supplier.

• The Supplier will raise a bill (or Bill of Exchange), and hand over the bill and the MTR / RRto the bank branch in Bombay for collection.

• The bank branch in Bombay will send the bill to the branch in Calcutta for collection.

• The bank branch in Calcutta will collect the payment from the Buyer and hand over theMTR / RR to the Buyer. The Buyer will be able to collect the goods from the TransportAgent against the MTR / RR. The bank branch in Calcutta will remit the payment collectedto the bank branch in Bombay.

• The bank branch will realize the bill when it receives the payment from the branch inCalcutta and credit the proceeds to the account of the supplier with the bank branch.

Collection of bill involves two separate operations. In the illustration above, the branch inBombay is the collecting branch and will send the bill out for collection. The branch in Calcuttawill be the correspondent branch which will receive the bill coming in for collection and remitthe money back to the collecting branch after receiving payment from the drawee of the bill.The bill will be referred to as the Outward Bills for Collection at the originating branch viz.Bombay branch and will be referred to as the Inward Bills for Collection at thecorrespondent branch in Calcutta.

During the time lag between the despatch of the goods and getting the payment, the suppliermay be short of funds to meet his working capital requirements. Here again the Supplier canavail of the banks services whereby, the bank will Purchase the bill raised by the supplier andgive immediate credit against it. The bank in turn will send the bill for collection. Once the bill isrealized, the bank will recover the credit given to the supplier from the bill realization proceeds.The bank earn commission for the collection of the bill and will also earn interest on theamount disbursed at the time of purchase of the bill. The interest will be charged for theduration between the date of disbursement and the date of realization. In case the buyer doesnot accept the bill, it is returned to the supplier and the amount advanced earlier by way ofpurchase is recovered. Commission and interest recovered at the time of purchase is,however, retained by the bank, in case of returned bill.



4.2 Documentation

There are two types of documentation in a trade transaction –

Financial Documents are those that are purely concerned with the payment

Commercial Documents are those that relate to trade and are concerned with the variousaspects of the transaction . Example – Invoice, Packing List, Transport documents like Bill ofLading, Insurance documents, etc.

4.2.1 Financial Documents

These are of two types -

4.2.1.1 Promissory Notes

They are drawn up by the party, which owes the money, and consist of a simple undertaking topay a certain amount. Bills of Exchange are much more widely used than Promissory Notes.

4.2.1.2 Bills of Exchange

A Bill of Exchange is

- An unconditional order in writing addressed by one party to other- Signed by the party giving it- Requiring the party to whom it is addressed to pay a certain amount of money- To pay on demand or at a fixed or determinable future time a certain sum of money- To a specified party or to order of a specified party or to bearer

Advantages of Bill of Exchange –

- They offer security for seller- They provide a channel of communication- They can be a means of extending credit

4.2.2 Commercial Documents

4.2.2.1 Commercial Invoice

The commercial invoice is a trading document sent by the seller summarizing the commercialtransaction

- Buyer- Quantity of Goods purchased- Specification- Price (Unit Price, Total Price, Discounts, etc.)- Terms of Shipment & Shipment Details

4.2.2.2 Transport documents

Different types of documents used for different methods of transport.

" Bill of Lading - A bill of lading is a transport document when goods are sent by sea.

" Airway Bill - It is a transport document when goods are shipped by air

" Road Consignment Note - Road Carriage usually involved the goods being delivereddirect to the premises of the consignee



" Truckway Bill - These are used when goods are transported by rail

" Freight Forwarders Receipt/Parcel Post Receipt - These documents are just receipts forgoods entrusted to a carrier. The goods will be delivered direct to the consignee by thefreight forwarder and the mail services respectively.

4.2.2.3 Insurance Documents

There are three types of insurance documents –

" Insurance Policy - Insurance Policy for the shipment of goods relate to a singleconsignment. The policy details will include –

- The insured value- The risks covered- The place and means of settlement of any claim

" Insurance Certificate - Exporters who make regular shipments overseas often have amaster policy for all their shipments. The exporter is the given a supply of insurancecertificates, one of which is completed for each consignment that is dispatched.

" Cover Notes - Cover Notes are issued by the insurance company of broker when a policyis still being prepared. They show that a consignment is insured but do not contain the fulldetails of the terms of the insurance.

4.3 Bills of Exchange

Let us now look at Bills of Exchange in detail.

Bill of exchange or simply Bill is an instrument, which directs the Buyer of goods to pay acertain amount to the Supplier of the goods or the bearer of the instrument.

Bill of exchange is defined as an instrument in writing containing an unconditional ordersigned by the maker, directing a certain person to pay a certain sum of money only to or to theorder of a certain person or to the bearer of the instrument.

Sample Bill of Exchange

Rs. 20,000.00 Mumbai, February 9th 2002

On DEMAND pay to STATE BANK OF INDIA or order the sum of Rs. Twenty Thousand only,for value received.

For M/s. Southern Chemical

Sd/- PROPRIETOR

ToM/s K.H.Trading Co.44, New MarketDelhi

You will observe from the above that the bill is signed by M/s. Southern Chemical and isaddressed to M/s. K.H. Trading Co., expressed to be payable to STATE BANK OF INDIA.Hence the parties in the bill are :

Southern Chemical - The Drawer



K.H.Trading - The DraweeState Bank of India - The Payee

4.3.1 Type of Bills

Demand Bill

This is a bill which is payable by the Buyer on demand (without any time lag). The Bill ofExchange begins with the words “ON DEMAND PAY …..”

Usance Bill

This is a bill which is payable by the Buyer of goods after a specified number of days. Ausance bill is raised when the drawer of the bill i.e. the supplier agrees to give a few days timeto the drawee i.e. Buyer of the goods for making the payment. In the usance bill raised thedrawer will specify that the bill is payable after a certain number of days from the bill date orafter a certain number of days from the date of presentation of documents.

When the narration on the bill reads “……days after date”, it means that the bill is payablethat many days after the date appearing on the face of the bill.

When the narration on the bill reads “……days after sight”, it means that the bill is payablethat many days after the date it is sighted and accepted by the drawee.

Documentary Bill

In some cases the supplier will submit the MTR / RR along with the Bill of exchange to thebank branch for collection. The Buyer of goods will be handed over the MTR / RR only afterthe payment is made. Such a bill will be termed as Documentary Bill since the bill isaccompanied by the document of title of goods.

Clean Bill

When the MTR / RR is sent directly to the buyer, and does not accompany the Bill ofexchange, the bill is termed as a Clean Bill. A normal cheque is another example of CleanBill.

Bill of Exchange

Demand Bill Usance Bill

Clean Documentary Clean Documentary

DocumentsAgainstPayment

DocumentsAgainstAcceptance



Documents Against Payment (DP) / Documents Against Acceptance (DA)

Although the payment may be made after the specified number of days, the MTR / RR may behanded over earlier or only upon payment. Based on this we have two further classificationsas described below.

Document against Payment of Bill or DP Bill is a bill which specifies that the “document oftitle of goods” will be handed over to the Buyer only upon payment of the bill.

Document against Acceptance of Bill or DA Bill is a bill which specifies that the “documentof title of goods” may be handed over to the Buyer upon acceptance of the bill. The Buyer willhave to write ‘Accepted’ and sign on the bill to signify acceptance of the bill. Acceptance of thebill signifies an assurance to pay the specified amount on the due date.

Bill Purchasing

The collection process of bill takes quite some time. In the intervening period the supplier maybe short of cash to meet his working capital requirements. Banks offer credit facilities againstbills outstanding by Purchasing the bill. Purchasing of Bill signifies that the bank will sendthe bill for collection, but against the bill the bank will give immediate credit to the supplier. Onthe amount disbursed, the bank will earn interest until the bill is realized. The bank willdisburse an amount equivalent to the bill amount less the margin amount which will be acertain percentage of the bill amount. Discounting of Bill is same as Purchasing of Billexcept that Discounting refers to credit against usance bills and Purchasing refers to creditagainst demand bills.

When a bill is purchased the bank may recover the margin amount from the customer’s otheraccount. The margin amount thus held will have to be transferred to the customer’s otheraccount after the bill is realized.

The margin amount will be debited from the Bill account and credited to the other account.Discount charges may be recovered from the margin amount.

4.3.2 Procedures followed at bank branches for operations related tobills purchasing / discounting and collection

We will discuss in this section the procedures followed by bank branches for operationsrelated to purchasing / discounting, collection of bills. We shall discuss the purchasing /discounting of bills in details. The procedure followed for collection will be along similar linesand will be discussed in brief.

4.3.2.1 Account Opening

Bill Purchasing / Bill Discounting (BP/BD) facility involves giving credit to the customer againstbills drawn by the customer. As in the case of any other credit facility, the bank branch has toappraise the customer as per the prescribed procedures. After the credit limit is sanctioned fora certain amount, the bank branch will purchase bills drawn by the customer subject to thecondition that the total credit outstanding is within the limit sanctioned.

In order to keep track of the credit limit utilized the bank maintains a Bill Register. In the BillRegister a separate page will be maintained for each account, and there will be provision totrack the actions on a bill right from the stage of purchase till it is realized / dishonoured.

An account need not be opened for the collection of bills since no credit is given to thecustomer. The bank collects the bill amount from the drawee, and makes payment to thecustomer when the bill is realized. Thus there is no risk involved. A separate register will bemaintained by the bank branch for keeping track of the collection operations. Usually only acustomer who has an account with the bank branch will give bills for collection.



The customer availing of the BP/BD facility will also have an associated Cash Credit / Currentaccount to which the BP/BD account will be linked. Upon purchase of a bill, the amount will bedisbursed to the corresponding CC / CA account. Commission and other charges will also becollected from the CC / CA account.

4.3.2.2 Purchasing, Discounting, Collection, Realization and Dishonour of Bills

The operations performed by the bank branch for various operations related to Bill Purchasing/ Discounting and Collection are as follows :

Purchasing / Discounting a bill

When the customer submits a bill for purchasing / discounting the bank branch will carry outthe validation checks to confirm that the bill may be purchased under the available credit limitfor the account, the transaction is genuine, the drawee has an unblemished record as far asmaking payments are concerned etc. If the purchase is valid, the bank branch will preparevouchers to credit the bill proceeds to the customer’s other account after deducting the marginamount, commission, interest and other charges.

An entry will be made in the Bill Register to record the bill purchase.

The bank branch will prepare a Bill Schedule specifying the details of the bill and otherdocuments which are sent, and other terms and conditions. The bill of exchange and otherdocuments will be attached to the Bill Schedule and sent by post to the other branch of thebank / branches of any other correspondent bank for collection.

The other branch which we will refer to as the remitting branch, on receiving the bill willprepare an intimation and send it to the drawee of the bill instructing him to make the paymentas per the terms specified. Vouchers will be prepared to pass contra accounting entries in theGeneral Ledger to reflect the contingent liability. The details of the bill will be recorded in theInward Bill for Collection Register.

Collection of Bill

The procedure followed for collection of the bill will be identical except for the fact that in caseof bill for collection, no credit will be given to the customer when the bill is sent for collection.Only after the bill is realized, the amount will be credited to the customer’s other account afterdeducting the commission and charges.

The administrative procedures will be identical. A separate register Outward Bills for CollectionRegister will be used to maintain bills sent for collection. When a bill is sent for collection, thebranch will prepare voucher to pass contra entries to record the contingent liability. Theseentries will be reversed when the bill is realized.

Details related to realization, dishonour of the bill will be recorded in the register.

Realization of bill

When a bank branch purchases / discounts a bill, the amount will be credited to the otheraccount of the customer and the bill will be sent for collection to some other branch of thebank. The other branch will intimate the drawee of the bill and after collecting the paymentfrom the drawee will remit the amount to the originating branch.

When the drawee makes the payment by cash / cheque, the remitting branch will remit thepayment to the collecting branch through credit advice, DD/PO/MT. The contra accountingentries passed when the bill was received, will be reversed. Based on the terms specified, theremitting branch will collect its own commission either from the drawee or deduct it from theproceeds of the bill before remitting.



The Collecting branch on receiving the payment will prepare vouchers to credit / debit theother account of the customer for the difference amount based on the amount realized. TheBill Register will be updated to record the realization of the bill.

The originating branch when it receives the payment will realize the bill i.e. settle the amountdisbursed against the bill purchased. In case of excess payment / short payment the differenceamount will be credited to / debited from the other account.

In case the payment is through a DD / Cheque (which will be the case usually), the originatingbranch will send the instrument for clearing. Only when the instrument is cleared will the bill berealized.

An advice will be sent to the customer to intimate the realization of the bill and the credit to theother account.

In case of dishonour of the bill the bank branch will advice the customer and recover theamount outstanding from the customer’s other account.

4.3.2.3 Dishonour of bill

When the drawee of a bill is not in a position to make payment towards the bill, the collectingbank branch will intimate the originating bank. The originating bank branch will mark the bill asdishonoured and proceed to recover the outstanding amount from the customer.

4.3.2.4 Deficiencies / Handicaps of the Manual Operations

The main deficiencies / handicaps of the manual operations are as follows :

• Considerable time is wasted in updating the Bill Register, preparing the Bill schedule to besent to the remitting branch, and other such administrative functions. Hence theoperational cost goes up.

• Human error in the computation of the commission, charges etc. leads to leakage ofincome.

• Details such as total limit utilization, income earned, statistics related to bills outstanding,settled etc. for a particular customer are not readily available.

• Information related to bill dishonoured and the corresponding drawees are not readilyavailable. This information will be necessary to take precautionary measures againstfuture default.

• A BP/BD account is linked to an other account (Current, CC/OD) to which the proceeds ofthe bill purchase are credited and from which charges etc. may be recovered. Usually theCurrent, CC/OD account is maintained by a different set of people. This results in flow ofvouchers to effect the other account and this often causes confusion due to misposting,misplacement of vouchers etc.



5. LETTER OF CREDIT

5.1 Concepts

Some of the basic definitions, rules governing Letter of Credit are discussed in this section.

Basic description of a Letter of Credit

Imagine that a buyer in Bombay, has placed an order for supply of certain goods, with asupplier in Calcutta (maybe in Bombay itself). There may be some time lag in the execution ofthe order. The buyer would not pay for the goods until he receives the goods. The supplier onthe other hand will not part with the goods unless he is assured that he will get his payment.

To overcome this stalemate, the bank acts as an intermediary, and opens a Letter of Creditfavouring the supplier. A Letter of Credit is an arrangement whereby, a bank agrees to makethe payment on behalf of the buyer to the supplier, upon receipt of certain documents,provided that certain terms and conditions as specified in the Letter of Credit are satisfied. Thesupplier of the goods would be specified as the beneficiary in the Letter of Credit.

• Letter of Credit is opened by a bank only for its own customers

When a bank branch issues a LC, its contingent liability goes up. The bank will have tomake the payment to the beneficiary as soon as he fulfills his obligations, as specified inthe LC. In the event of the buyer not being able to pay, the bank will have to incur theloss. Thus the bank in order to safeguard its own interests will open LC only for its owncustomers who enjoy a credit limit for the purpose.

LC is opened at the request of the customer. The customer has to fill in the LC applicationform, and along with it submit the relevant documents like Purchase Order. The LCapplication form contains all the relevant details to be included in the LC like beneficiarydetails, shipment details, merchandise details etc.

• Bank should ensure the authenticity of the documents submitted, and also ensure that theLC amount is within the available credit limit for the account.

The officer at the branch should ensure the authenticity of the documents submitted toverify that the LC is being opened to facilitate a genuine business transaction and that thedetails specified in the LC application form are consistent with the terms specified in thesupporting documents. He should also verify that the LC amount is within the availablelimit.

• LC is prepared in a standard specified format and sent to the beneficiary

The bank branch would prepare the LC in the standard specified format, get it typed onsecurity paper (called LC Form) and send it to the beneficiary. The LC may be sent directlyto the beneficiaries or routed through a correspondent bank / branch for operationalconvenience.

• LC document will include the following details

! Primary details regarding the LC issued like value of LC, type of the LC etc.! Details of the Beneficiary! Details regarding the shipment of goods! Details regarding the merchandise

• When a Letter of Credit is issued, contra entries are passed to the relevant ContingentLiability accounts in the General Ledger.



• Commission, Postage, Commitment Charges and Margin on the Letter of Credit amountare debited from the customer’s Current or CC/OD account, and credited to thecorresponding Income accounts.

• Amendment of Letter of Credit

An LC may be amended either to change the LC amount or to modify any of the terms likeexpiry date etc. In case the LC amount is increased the charges related to the additionalamount will be deducted from the customer’s other account and credited to thecorresponding Income Accounts in the General Ledger.

• Closure of Letter of Credit

Upon receipt of the relevant documents from the beneficiary the bank branch wouldrelease the payment through a draft or TT. The bank branch would pass appropriatecontra GL transactions to reduce the contingent liability.

5.2 Common Terminology

Irrevocable Letter of Credit

An irrevocable LC cannot be cancelled or amended without the consent of the parties to thecredit.

Confirmed Letter of Credit

The bank in U.K may not agree to discount an LC issued by a certain bank in India, and mayinsist that the LC is also confirmed by an acceptable bank in U.K. Such an LC would be calleda confirmed Letter of Credit.

Revolving Letter of Credit and Revolution of Letter of Credit

There are instances wherein the agreement between the buyer and supplier may stipulate theregular supply of certain quantity of goods, say, every two months. In such cases instead ofopening an LC every two months, it would be better to open a LC wherein the terms providefor automatic renewal of the LC for the specified amount. Such an LC would be called arevolving Letter of Credit and the renewal operation is called revolution of Letter of Credit.

Advising Bank, Correspondent Bank, Confirming Bank, Reimbursing Bank

Consider the following illustration :

An purchaser in Bombay is buying certain goods from a company in say, Calcutta. Thesupplier in Calcutta would ask the Purchaser to furnish a Letter of Credit. The Letter of Creditwould specify all the terms applicable as per the agreement between the Purchaser andSupplier. The Supplier will be named as the beneficiary in the Letter of Credit.

The Supplier needs to be informed that a Letter of Credit has been issued in his favour, so thathe may despatch the goods as per the contract. The issue of the Letter of Credit iscommunicated to the Supplier through a bank branch in Calcutta. Since the bank issuing theLetter of Credit may not have a branch in Calcutta, the communication may be routed throughsome other bank. Such a bank is referred to as the Advising Bank.

In some cases, the supplier in Calcutta may not be satisfied by the Letter of Credit issued bythe bank in Bombay, and may ask for confirmation by a recognized bank based in Calcutta aswell.



When a confirmation is required, a bank branch in Calcutta may add its confirmation to theLetter of Credit. In the event of the Purchaser not being able to pay for the goods, under theterms of the Letter of Credit, the bank in Bombay will be liable to pay the supplier. In case abank in Calcutta has confirmed the Letter of Credit, then even that bank is liable to pay thesupplier in case the bank in Bombay is not able to pay. The bank in Calcutta will be called theConfirming Bank.

Bank may not have offices in all the cities / states. When a bank branch issues a Letter ofCredit, and the beneficiary happens to have his office in a city where the bank has no branch,then to carry out the operations like advising the Supplier etc., the bank may enter into arelationship with some other bank which will function as a Correspondent bank. The twobanks may have some agreement on sharing of charges etc.

5.3 Procedures followed for operations related to Letter of Credit

The main operations related to Letter of Credit are as follows :

• Account Opening and Sanctioning of Limit for Issue of Letter of Credit• Issue, Amendment, Cancellation / Closure of Letter of Credit, and the administrative,

accounting functions relating to these operations.

5.3.1 Account Opening

Letter of Credits are issued by a bank branch only to its own customers. The customer has tomake an application for opening a Letter of Credit account. The bank would sanction the limitafter appraising the client as per the specified procedure.

Once an account is opened, a separate page is opened in the Letter of Credit Register and thebasic details regarding the account are recorded. All further activities like issue of LC,amendment etc. are recorded in the LC Register.

While opening the account the main task to be performed will be the credit appraisal of thecustomer based on past performance, documents submitted etc. and sanctioning of the limit.

The Credit Appraisal and Sanctioning of the credit limit need not be done specifically for Letterof Credit Account. Very often when credit limits are sanctioned by bank branches (IndustrialFinance Branches) to big companies, an overall credit limit is sanctioned based on the creditappraisal carried out. Under the overall limit, various facilities may be availed by the customer.

5.3.2 Issue, Amendment, Cancellation, Closure of Letter of Credit

5.3.2.1 Issue of LC

A customer who wants a Letter of Credit to be issued, has to make an application in theprescribed form. The LC application form will have all the details to be specified in the LCissued. The officer concerned would verify the authenticity of the contract documentssubmitted, and issues the Letter of Credit, by typing the LC in the LC form. The bank thendespatches the LC to the supplier through a correspondent bank / branch. The bank generallyensures that the LC amount is within the available limit in the account

The details of the LC issued will be recorded in the LC register. The officer will raise thevouchers for posting the entries in the General Ledger.

The details captured while preparing the LC are –

• Primary Details of the LC like whether the FOB value or the CIF value is considered forissuing the LC, the type of the LC, whether it is confirmed LC, the Purchase OrderNumber, whether it is a revolving LC etc.



• Beneficiary Details i.e. the name and address of the supplier of the goods beingpurchased, and who will usually be mentioned as the beneficiary in the LC issued.

• Bank Details which will include the name of the banks which will act as the advising bank,confirming bank (if required), Paying bank and reimbursing bank.

• Shipment Details like the mode of shipment, date of shipment, the last date fornegotiations, whether any transshipment is involved, the origin and destination of theshipment etc.

• Document Details i.e. the list of documents submitted by the customer.

• Merchandise Details which will basically be a description of the merchandise / goodsbeing supplied as listed in the Purchase Order.

• Reimbursement Instruction which pertains to the mode of reimbursement.

• Special Instructions which could be other than the normal instructions which need to bementioned in the Letter of Credit are captured.

• Collection of Charges

The charges for issue of Letter of Credit are collected upfront at the time of issuing of theLC. The charges which are usually collected are the following:

Sight Commission - Sight commission pertains to the commission which is collected onsight LC.

Usance Commission - Usance commission pertains to the commission for the usanceperiod.

Postage - Expenses incurred towards postal charges for despatching the documents.

Margin - A margin of the LC amount (specified in percentage while opening the LCaccount) is collected from the customer’s other account. The margin amount is credited tothe customer’s other account upon closure / cancellation of the LC. The margin can alsobe taken in the form of a Fixed Deposit Receipt in which case, the other account is notdebited. In case of some reputed clients the bank may decide not to take the marginamount.

When a bank branch issues a Letter of Credit, then it has an obligation to pay the beneficiaryin the event of the customer not being able to meet his commitments.

Hence the bank branch has to strictly follow the guidelines issued while carrying outoperations related to Letter of Credits.

A considerable time is taken up in typing out the LC Form and this is the main activity.

Similarly in the case of amendment, cancellation and closure the LC Register is updated,appropriate vouchers are raised to effect the accounting in the General Ledger. Strictguidelines have been laid down for each of the above operations. As an example, amendmentof the Letter of Credit cannot be carried out without the confirmation from the drawee.

5.3.2.2 Amendment of Letter of Credit

Amendment of a LC might arise because of a change in the LC amount or other termsspecified in the LC. An amendment requires the consent of both the parties to the credit.



On amendment, the transactions passed will be similar to the transactions on issue of Letter ofCredit. However, in the case of amendment of Letter of credit, only the adjustmenttransactions will be passed i.e. the contra transaction for the contingent liability will be for thedifference in the LC amount, the Sight and Usance commission will be calculated for thedifference in the LC amount and only the incremental charges will be passed.

5.3.2.3 Cancellation / Closure of Letter of Credit

An LC can be cancelled at the request of the customer. On reaching the expiry date a LC isclosed. In either of the above two operations, the contingent liability in the General Ledger is tobe reversed. In the case of cancellation, cancellation charge if any is collected.

5.3.2.4 Deficiencies / handicaps of the Manual Operations


• Considerable time is wasted in typing out the Letter of Credit and other such administrativefunctions. Hence the operational cost goes up.

• The computation of the commission on Letter of Credit is quite complicated and the branchpersonnel has to refer to the schedule of charges to compute the commission correctly.Under the manual operations, the probability of committing error is high.

• The branch personnel have to maintain additional diaries, registers to keep track of LCsexpiring, Exposure to a customer etc.



6. GUARANTEES

6.1 Banking Terms, Concepts, Practices governing Bank Guarantees

In this section the basic definitions, rules governing Bank Guarantees are discussed.

Basic Description of a Bank Guarantee

Consider the following illustration :

Illustration 1

A Company floats global tender inviting companies to bid for a contract for executing aconstruction project. The company would like to ensure that only serious bidders who have thecapability to execute the job satisfactorily submit a tender. The opportunity cost to thecompany in terms of time and effort lost will be considerable, if bidders who are not veryserious decide to drop out at an advanced stage. This may be achieved by asking the biddersto deposit a certain amount as earnest money. The bidder will have to forfeit the earnestmoney in case he decides to drop out.

Illustration 2

After the bids are evaluated, suppose the contract for execution of the job is awarded to acontractor. The company would like to ensure that the contractor executes the project as perthe agreed schedules and also that the solution provided meets the performance normsagreed to. Here again the cost in the form of lost opportunity will be considerably high in caseof any delay in the completion of the project. The company may ask the contractor to deposit acertain amount with the company to cover its losses.

In both the situations above the company expects the contractors / bidders to deposit a certainspecified amount with the company. This may not always be feasible / desirable for thecontractor, as the money deposited with the company will be locked up for some time. Thecontractor then looks for an alternative whereby the company’s requirements are met and atthe same time his money is not locked up. This alternative is provided by the Bank Guarantee.

Under a Bank Guarantee Contract the bank executes a guarantee in favour of the companyguaranteeing payment of the specified amount in case the contractor drops out of the bid ordefault in the execution of the contract.

A Bank Guarantee may be defined as a contract whereby the bank guarantees todischarge the liability of a third person in case of his default.

In the situations illustrated above, when the bank executes a guarantee, the bank undertakesto pay on behalf of the contractor in case he defaults. It should however be noted that theguarantee issued by a bank should be acceptable to the company in lieu of the deposit. Alsonote that the bank does not undertake to execute the contract on behalf of the contractor. Thebank only undertakes to make good the loss incurred in monetary terms. Thus the liability ofthe bank will be in monetary terms only.

In the first illustration above, the bank issues a guarantee in lieu of the earnest money depositi.e. a guarantee is issued in lieu of a financial liability. Hence such a guarantee may bereferred to as Financial Guarantee. In the second illustration, the bank issues a guaranteepromising to make good the monetary loss in the event of the contractor not meeting theperformance obligations. Such a guarantee may be referred to as Performance Guarantee.

The above illustrations also bring forth the three parties to a bank guarantee contract viz. thecompany, the contractor and the bank. The company is the beneficiary, the contractor is theprincipal debtor and the bank is the surety or guarantor.



Deferred Payment Guarantee

Suppose that a company which we will refer to as buyer places an order with anothercompany to be referred as Supplier for supply of certain machinery. The cost of the machinerymay be so high that the buyer may not make the full payment at the outset. The paymentterms may stipulate immediate payment of a certain small percentage of the cost and paymentof the remaining amount in installments.

In such an event, the supplier may ask for a bank guarantee to ensure the timely payment ofinstallments. The bank in this case will have to issue a guarantee promising to pay theinstallments on behalf of the buyer, in case the buyer defaults. This type of guarantee isreferred to as Deferred Payment Guarantee. At the time of issue of the guarantee therepayment schedule will be specified.

Difference between Letter of Credit and Guarantees

In many ways a bank guarantee is similar to a letter of credit. The essential difference betweenthe two is with regard to the purpose for which each is used. A letter of credit is anarrangement whereby the bank agrees to make payments on behalf of the buyer of certaingoods to the supplier, upon receipt of certain documents provided other terms and conditionsare satisfied. Thus a Letter of credit is essentially linked to a trade transaction. A guarantee onthe other hand is not essentially linked to a trade transaction. A Bank Guarantee is a contractwhereby the bank guarantees to discharge the ability of a third person in case of his failure tomeet certain performance / financial commitments. A relook at the examples given earlier willhelp understand this better.

Procedure for Issue of Bank Guarantee

The procedure / guidelines for issue of guarantees are as follows :

• Guarantees are usually issued only to the customers of the bank branch who enjoy acredit limit for the purpose.

• The customer has to submit the application form together with a copy of the guaranteecontract sought by the beneficiary.

• Under the bank guarantee contract, the bank is liable to pay the beneficiary when the latterinvokes the guarantee. Hence the bank officials will have to scrutinize the documents andthe terms specified in the guarantee contract carefully in order to safeguard the banksinterests. The bank official must be convinced about the capacity of the customer to fulfillthe contractual obligations. The bank official should among other things ensure that theguarantee is applicable for a definite period, the liability is limited to a specific amount, theunderlying trade transaction is bonafide, the guarantee is issued for a definite objectiveetc.

• The bank branch will obtain a counter guarantee from the customer so that the bank mayrecover the amount paid to the beneficiary when the guarantee is invoked.

• The bank branch should obtain adequate collateral security, margin amount from thecustomer. The extent of collateral security to be obtained, the percentage of the guaranteeamount to be deposited as margin will however be dependent on the credibility of theborrower.

• The bank will earn income on guarantees issued in the form of commission. Thecommission is collected at the time of issue of the guarantee. In case a guarantee iscancelled by the customer before the expiry date then the customer may be refunded partof the commission amount collected.



• Guarantees issued will be recorded in the Guarantees Issued Register. In the guaranteeregister the details of various accounts enjoying credit limit will be maintained on separatepages. The Guarantee Register has columns to keep track of the various details regardingthe guarantees right from issue until it is cancelled / closed / invoked.

The details recorded in the Guarantee Register for each guarantee issued will include thename and address of the beneficiary, amount of guarantee, purpose of the guarantee,security obtained, margin amount, commission collected, and date of expiry of theguarantee.

• The accounting entries passed when a guarantee is issued are as given below.

Effect on the Bank’s Liability

Cr. Guarantees Issued A/C by Guarantee AmountDr. Customer’s Liability on account of Guarantees issued by the Guarantee Amount

Effect on the P&L Account

Cr. Commission earned on Bank Guarantees by commission amountDr. Other A/C / Cash Head by the commission amount

Example

If a guarantee is issued for Rs. 25000 and the commission computed is Rs. 50/- which isdebited from the other A/C then the accounting entries will be as given below.

Cr. Guarantees Issued 25000Dr. Customer’s liability on a/c of guarantees issued 25000

Cr. Commission earned on Guarantees issued 50Dr Other A/C or Cash Head 50

• The bank official will diarise the expiry of the guarantee i.e. make an entry in a diarymaintained by which they will know that on the date of expiry the liability of the bank aswell as the customer are to be reversed and the status of the guarantee is to be updated inthe Guarantee Register.

• The bank branch will prepare the guarantee contract as per the guidelines mentionedabove. The guarantee will be signed by an authorized official at the bank branch andhanded over to the customer.

6.2 Procedures for maintenance of Guarantee Accounts

The procedures followed at bank branches for maintenance of Guarantee accounts are similarto those for Letter of Credit accounts.

The main operations related to Guarantees are as follows :

• Account Opening and Sanctioning of Limit for issuing bank guarantees• Issue, invocation, settlement, surrender, closure of guarantees

6.2.1 Account Opening

Bank branches usually issue guarantees only to its own customers who have a limitsanctioned for the purpose. A customer wishing to have a limit for guarantees will have tomake an application to the bank together with other support documents. The bank will sanction



a limit after appraising the customer. The appraisal may be done specifically for the guaranteeaccount or for an overall credit limit for the customer.

When a guarantee account is opened, a separate page is opened in the Guarantee Registerand the basic details regarding the account are recorded. All further activities related toguarantees will be recorded in the Guarantee Register. Details such as the sanctioned limit forperformance guarantees, financial guarantees etc. will be available in the guarantee register.

6.2.2 Issue, Amendment, Invocation, Settlement, Surrender, Closure ofguarantees

6.2.2.1 Issue of Guarantee

The bank will issue a guarantee at the request of the customer. The customer needs to have aguarantee account with a credit limit. The customer will have to submit the guaranteeapplication form and a copy of the guarantee contract desired by the beneficiary (if any).

At the time of issue of guarantee the bank officials have to scrutinize the contract paperscarefully to ensure that the interests of the bank are safeguarded. The guidelines laid down forscrutinizing documents should be strictly followed. The customer, who wants a guarantee tobe issued, has to make an application in the appropriate application form. In case thebeneficiary desires the guarantee to be in a specific format then the customer has to submit acopy of the contract along with the application form. The bank officials will scrutinize if thecontract is in order.

Once all the details are verified the bank will type out the guarantee contract on the specialstationery and hand it over to the customer. The details of the guarantee issued will berecorded in the Guarantee Register. Vouchers will be raised to pass the appropriateaccounting entries in the General Ledger. The branch maintains a separate file for circularsrelated to charges like commission. The commission will be computed as per the schedule ofcharges and vouchers will be raised for collecting the charges. In case the commission andmargin amounts are to be recovered from the other account of the customer with the branch,then a debit voucher will be raised and sent to the department maintaining the other account todebit the other account.

Similarly for all the other operations related to guarantees, the details will be recorded in theGuarantee Register and vouchers will be raised for the accounting entries.

To summarize, the activities performed at the branch are mainly administrative and involvesscrutinizing of the documents and contracts. The processing in terms of accounting andmaintenance of ledgers are relatively simpler and do not take up much time. However due tothe time spent in carrying out the administrative functions it typically takes a day for the bankbranch to issue a guarantee.

6.2.2.2 Amendment of Guarantee

Subsequent to the issue of a guarantee it may be required to modify the certain details like

! Date from which the guarantee is effective! Date of expiry of the guarantee! Date upto which claim can be made on the guarantee! Guarantee amount

If the guarantee amount or the expiry date is advanced, additional commission , margin mayhave to be collected.

6.2.2.3 Invocation of Guarantee



The beneficiary will invoke a guarantee in case the principal debtor (who will be a customer ofthe bank branch) does not fulfill the commitments as specified in the bank guarantee contract.The beneficiary will make a claim directly to the bank branch.

When a guarantee is invoked the bank branch has to settle the claim if the principal debtor asspecified in the contract has not fulfilled the commitments. Usually there will be some delaywhile the bank processes the claim.

In the case of Deferred Payment Guarantees the invocation will pertain to a particularinstallment.

6.2.2.4 Settlement of Guarantee

Once the beneficiary invokes a guarantee the bank branch will have to settle the claim if it isevident that the principal debtor has not fulfilled the commitments specified in the bankguarantee contract.

6.2.2.5 Surrender of Guarantee

The customer may surrender the guarantee to the bank before the expiry of the guarantee.The guarantee may be surrendered either because the customer does not intend using it orbecause the guarantee has served its purpose and the beneficiary returns it to the principaldebtor.

6.2.2.6 Closure of Guarantee

A guarantee can be closed only after the expiry date and the date upto which claims arepermissible against the guarantee.

6.2.2.7 Settlement of Guarantees Paid

When the beneficiary invokes a guarantee, the bank has to settle the claim if the terms of thecontract are satisfied. The claim may be settled either by recovering the settlement amountfrom the customer’s other account or alternately the bank will make the payment. In case thebank makes the payment, then the amount will be debited from a GL account ‘GuaranteesSettled’. On a later date, when the amount can be recovered from the customer’s otheraccount, the bank will debit the customer’s other account and credit the GL account.

6.2.2.8 Deficiencies / handicaps of the Manual Operations


• Considerable time is wasted in administrative functions. Hence the operational cost goesup. Also the time required for issuing guarantees also goes up.

• Computation of commission and other charges are error prone leading to leakage ofincome.

• Voucher flow between departments cannot be avoided. This leads to confusion anddiscrepancy at the time of tallying of the General Ledger / DayBook.

• Considerable time is spent in generation of statistics, keeping track of guarantees expiringetc.

Date post:	05-Jul-2020
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