Category: Management Notes

Management Notes

Procedure and Practice in Opening and Operating Accounts of different Customers

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Finding and opening a bank account can seem intimidating given the sheer number of options out there. Fortunately, most banks and credit unions follow a straightforward process similar to the one described below. Getting your account open is just a matter of picking a bank, providing certain details, and funding your account. Once the formalities are done, you can start using your account—and save time and money.

Choose a Bank or Credit Union

You might already know where you want to bank even if you don’t know how to open an account there. If not, shop around. Start by finding the best match for your immediate need (a checking account or savings account, for example). As you compare institutions, be mindful of account usage restrictions and fees that can eat into your savings.

There are three basic categories of financial institutions:

Banks, including community banks and big banks: These might be well-known brands in your local community (or nationwide). They offer most of the basic services you need. Local and regional banks tend to have more friendly fee structures, but it may be possible to get fees waived at big banks.

Credit unions: A credit union is a customer-owned financial institution that provides many of the same services and products that banks provide. If you join one of these not-for-profit institutions, you’ll often enjoy competitive rates because they’re not necessarily trying to maximize profits. But that’s not always the case so review fee schedules carefully.

Online banks and credit unions: These institutions operate entirely online. There’s no branch to visit (or pay for), and you’ll handle most service requests yourself. If you’re comfortable with your computer or mobile device and performing basic banking transactions an online bank can help you reduce your fees, earn higher interest rates on savings accounts, and even get free checking.

You don’t have to pick just one type of bank. For example, it’s wise to open an online bank account and keep your brick-and-mortar bank to keep your fees low and maintain the ability to visit a bank in the event of a financial emergency.

Visit the Bank Branch or Website

The easiest way to open an account is to visit the institution’s website. Search for the bank online, or visit the website listed on the bank’s marketing materials (be careful when you type in the web address impostor sites with similar names may exist).

The advantage of opening accounts online is that you can do it at any time, from anywhere. But if you’re only comfortable opening accounts in person, show up at the branch during business hours. Before you leave the house, have the following items ready:

  • Your government-issued ID (such as a driver’s license, passport, or military ID)
  • Your Social Security Number
  • Your physical and mailing address
  • An initial deposit (if required)

Pick the Product You Want

Once you settle on the bank where you want to open an account, you’ll generally have a variety of account types and services to choose from, including:

  • Checking accounts: Use these for making payments and receiving direct deposits.
  • Savings accounts: These accounts allow you to earn interest.
  • Money market accounts: These products sometimes earn slightly more interest than savings accounts (while maintaining your access to cash).
  • Certificates of deposit (CDs): These products can earn much more than savings accounts but require you to lock up your funds for a certain period.
  • Loans: You can take out one of several types of loans (auto, home, personal loans, for example).

Within one of the above categories, a bank may offer multiple products, each with a different name and level of service. Premium accounts that come with more features have correspondingly higher fees (like monthly service fees, ATM fees, and overdraft fees) and higher thresholds to avoid the service fee.

Pick the option that has a mix of features and fees that meet your needs and budget. For example, if you’ll keep a low balance in the account, you may want to open a bank account with no or low fees.

When viewing a bank’s products online, you might have to drill down to the product that is right for you. For example, you might have to click “Open an Account,” and then click “Checking” and peruse the options for free checking. If you open your accounts in person, chat with a banker to find the best account for your needs. Of course, you’ll only want to bank where your money is protected by FDIC insurance (or NCUSIF coverage if you use a credit union).

Provide Your Information

As you open a new bank account, you’ll need to provide sensitive information to the bank. To protect themselves and comply with regulations such as the Patriot Act, banks can’t open an account without verifying your identity.

You’ll need to provide simple details like your name, birthday, and mailing address, as well as identification numbers (in the United States, this is most likely your Social Security Number). You’ll also be asked to present a valid government ID (such as a driver’s license or passport).

If you’re opening a bank account online, you’ll type this information into a text box. If you set up your accounts in person, be prepared to hand your ID to the banker, who will probably photocopy it.

Your Financial History

You don’t need a squeaky clean history for a bank account, but it helps. Many banks check your credit to see if you’ve had problems repaying loans in the past. These credit checks are usually “soft” pulls that do not damage your credit but it’s best to ask, if you’re concerned. You don’t necessarily need good credit to get a bank account, but having bad credit can sometimes lead to denials.

Consent to the Terms

You’ll have to agree to abide by certain rules and accept responsibility for certain activities in your accounts. When you open an account at a bank, you form a relationship based on an important subject: your money. Therefore, you should know what you’re getting into. If you open bank accounts online, you’ll complete this step by clicking the “I Agree” (or similar) button and moving on to the next step.

Under 18?

If you’re under 18 years old, you’ll need somebody over age 18 to open the account with you. You still might be able to use a debit card and online banking, and you can eventually get your own account. But banks need at least one adult on an account to get you started.

Joint Accounts

If you’re opening a joint account of any kind, you’ll need the personal information for all of the account holders and a signature from each of them. It’s best to get everybody together in one place to complete the application.

Although disclosures have improved over time, there are a lot of important details buried in the fine print when opening a bank account. In particular, you’ll want to know about any fees applicable to your account, and when your funds will be available for withdrawal.

In addition to bank agreements, federal law dictates your rights and responsibilities as an account holder. For example, if somebody takes money out of your account fraudulently, you might be protected against losses. However, you may need to report the withdrawal quickly for full protection.

Print, Sign, and Mail (If Required)

If you’re opening a bank account online, you may have to print, sign, and mail a document to the bank before the account is opened. Some banks use electronic disclosure and consent to make the banking relationship legally binding you can do everything online. Others still require a signed document to open an account. Until they receive the documents, your account is not active.

Fund Your Account

If you’re opening a checking or savings account, you’ll often need to make an initial deposit into the account. Sometimes, this is required as part of the opening process, and other times, you can do it after the account is up and running. There are several ways to fund your account:

  • Deposit cash: It should be available for spending with your debit card by the next day.
  • Deposit a check or money order: The funds should be available within a few business days after you make the deposit.
  • Set up direct deposit with your employer: Instead of getting a paycheck, your earnings will be sent directly to your new account.
  • Transfer funds electronically: Move money from an external bank account to make your initial deposit.
Management Notes

Types of Customers and Account Holders

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The term customer of a bank is not defined by law. Ordinarily, a person who has an account in a bank is considered as its customer. Banks open accounts for different types of customers like an individual, partnership firm, Trusts, companies, etc. While opening the accounts the banker has to keep in mind the various legal aspects involved in opening and conducting those accounts and also practices followed in conducting those accounts. Normally, the banks have to deal with following types of customers.

Types of customers

  1. Individuals

An individual can be a person holding a bank account for personal use. Such customers must comply with existing regulations and bankers must ensure that they do not open and use bank accounts for illegal purposes. The customer should be properly introduced to the bank. The introduction is necessary for terms of banking practice and also for the purpose of protection.

(i) Minors

A minor is a person who has not completed eighteen years of age. Any contract entered by minor is void and is not enforceable by law. This prevents minor to acquire property, dispose property or enter into any type of agreement. Guardian means a person having the care of the person of a minor or of his property or both person and property. Guardians may be categorised into following three types:

  • Natural guardian
  • Testamentary Guardian
  • Legal Guardian appointed by a court

(ii) Joint account

A joint account is an account which is opened by two or more persons jointly. It’s simply a joint debt such an account is opened by them for the convenience of the operation of the account as well as for the withdrawal of money after the death of any one of them.

(iii) Married Woman

A married woman is competent to enter a valid contract. Therefore banker opens an account in the name of a married woman. In the case of a debt taken by a married woman her husband shall not be liable except in the following circumstances:

  • If she borrows money for the necessities of her life
  • If she borrows for the necessaries of her household
  • If she acts as an agent of her husband.

(iv) Pardanasheen Women

A paid ana sheen woman observes complete seclusion in accordance with the custom of her own community. She does not deal with the person other than the members of her own family. As she remains completely secluded as the presumption in law. The banker should take due precaution in opening an account in the name of a park ana sheen woman. As the identity of such a woman cannot be ascertained, the banker generally refuses to open an account in her name.

(v) Illiterate Person

Illiterate persons cannot sign their names and hence the bankers take their thumb impression as a substitute for signature and a copy of their recent photograph. The application form and photograph should be attested by an approved witness. For withdrawing money he must attend personally and affix his thumb impression in the presence of an official of the bank for identification.

  1. Joint Hindu family

Joint Hindu family it’s an undivided family which comprises of all male members descended from a common ancestor. A Joint Hindu Family is a family which consists of more than one member possesses ancestral property & carries on family business. The senior male member is called “Karta” and other male members as “coparceners”. Karta manages the whole business of the family and the liability is unlimited whereas coparceners have limited liability. Coparceners can be appointed as managers. The Karta has the power to mortgage and pledges the property of JHF for raising the loan.

  1. Joint stock companies (Limited Liability Companies)

If a company is registered under companies Act has a legal status independent of the shareholders. A company is an artificial person who has a perpetual existence with limited liability and the common seal.

  • Memorandum
  • Articles of Association
  • Certificate of Incorporation
  • Resolution passed by the Board to open account
  • Name and Designation of person who will operate the account with details of restriction placed on them

These are the essentials documents required to open an account.

  1. Unincorporated Associations

Banks open accounts of unincorporated associations and clubs started for purposes of Sports, Recreation, Promotion of Fine Arts, and Education etc. Accounts are opened for reliable and reputed parties. These unincorporated associations have no legal entity. While opening an account in the name of association the bank makes detailed inquiry in the existing rules and regulations governing such associations. All usual formalities for opening the account are adhered by the bank. Bank also obtains the certified copy of the resolution passed by the Governing Body for an opening of the account in the bank and names of the office bearers authorised to open and to operate the account on behalf of the association duly certified by the Chairman are obtained.

  1. Societies, Clubs and Associations

A society gets legal entity only when it is incorporated under Company’s Act. Bylaws of the society, clubs and association contain rules, regulations or conduct and activities of the association. While opening account the banks obtain following from the clubs:

  • Copy of the bylaws
  • Copy of resolution passed by the managing committee regarding opening and conduct of account
  • Certificate of registration in original
  • A list of the Managing Committee members
  • Copies of resolutions for electing them as Committee members duly certified by the Chairman.

Bank keeps a copy of all the above-mentioned documents for its record.

  1. Partnership Firms

A partnership is a relationship between persons who have agreed to share the profits of a business carried on by all or any of them acting for all. Since a firm is not a person is not entitled to enter into the partnership with another firm or Hindu undivided family or individual. Therefore banks do not an open account where a firm is a partner of another firm. As per the Indian Partnership Act, the minimum number of partners can be two and maximum twenty. The number of partners is restricted to 10 if the partnership firm carries out business for banking. Minors can be admitted as the partner only to the benefits of the partnership.

  1. Trustees

Trusts are created by the settler through executing a Trust Deed. A trust account can be opened after obtaining and scrutinising the trust deed. The Trust account has to be operated by all the trustees jointly unless provided in the trust deed. A cheque favouring the Trust shall not be credited to the personal account of the Trustee. According to the Indian Trusts Act, a ‘trust’ is an obligation annexed to the ownership of property, and arising out of a confidence responded and accepted by the owner or declared and accepted by him for the benefit of another and the owner. The person who responses the confidence is called the author of the trust. The trustee is the person in whom the confidence is responded. The person for whose benefit the trust is formed is called beneficiary.

The customers of banks consist of millions of private individuals, hundreds of thousands of small businesses formed as private limited companies. Some persons like the minors, drunkards, lunatics and insolvent are not competent to enter into valid contracts. Some persons like agents, trustees, executors, etc. who act on behalf of others, have limitations on their powers. Thus requires extra care to ensure that their accounts are conducted in accordance with the provisions. These are the major types of customers that come under banking operations.

Types of Account Holders

Accounts of Individuals

Individuals generally open transaction accounts like Savings accounts or Current accounts. It has already been mentioned that any adult person/individual competent to contract can open any account with any bank after observing usual formalities provided that the bank is satisfied about his identity, respectability and desirability. On many occasions, identity is ascertained by the passports, voter identity cards (ID), certificates of ward commissioners, employer’s certificates, and tax identification numbers (TIN) etc. They are required to furnish passport size photograph and an introduction from an acceptable person. Normally individuals either singly or jointly are allowed to open Savings account.

Joint Accounts

Accounts are allowed to be opened in two or more names (individuals). Documents required are similar to those applicable to the individual accounts. In case of joint accounts, generally ‘Either or Survivorship’ instructions are obtained in hand writing of the account holders concerned under their signatures. In such cases account may be operated by anyone of them. In the event of death of either one, survivor can operate the account. In the absence of instructions otherwise in the ‘Either or Survivorship’ declaration, the balance of the joint, account is payable to the survivor and the legal representatives of the deceased joint account holder if there is no nomination.

Accounts of Sole Proprietorship

The sole proprietorship concerns do not enjoy any legal status. Hence they are treated like individuals by the banks. While opening a new Current account, the owner is required to produce the trade license, certificate from Chamber of Commerce, Tax Identification number (TIN) and Value Added Tax (VAT) registration number as may be applicable or similar other document. In case of savings accounts, documents required are similar to those applicable to individual accounts.

Accounts of Partnership Firms

A partnership account is allowed to be opened by the banks on production of trade license and other documents evidencing the partnership business. If it is registered partnership it is required to produce registration number and partnership deed. If not, a standard partnership letter supplied by the banks is required to be signed by all the partners of the ‘firm’ in their individual capacities. Account may be in the name of the ‘firm’. But legally firm does not have any existence. Hence partners jointly and severally have to bear all the responsibilities.

The partnership deed or partnership letter is thoroughly studied by the banks to ascertain the names and addresses of all the partners and nature of business. The names of the partners authorized to operate the account on behalf of the firm including the authority to draw, endorse and accept bills, mortgage and sell property belonging to the firm etc are also ascertained from the Deed or Letter. Banks also ascertain the position of the firm on retirement or death or insolvency of any of the partners.

Management Notes

Regulations of Priority Lending for Commercial Banks, Need, Challenges

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Priority Lending refers to the directive by the Reserve Bank of India (RBI) requiring commercial banks to allocate a certain portion of their lending portfolio to priority sectors. These sectors include agriculture, micro, small and medium enterprises (MSMEs), export credit, education, housing, and weaker sections of society. The objective is to ensure that credit flows to underserved sectors, supporting economic growth, employment generation, and social development. Priority sector lending (PSL) helps banks fulfill their social responsibility while contributing to balanced regional development and reducing income disparities. The RBI sets targets for priority sector lending, typically around 40% of total adjusted net bank credit for domestic banks.

Commercial banks must follow RBI guidelines on lending limits, interest rates, and credit appraisal for priority sectors. These loans often carry subsidies or concessional rates to encourage lending. Effective implementation of PSL requires proper monitoring, reporting, and risk management, as these loans may carry higher default risks. Priority lending strengthens financial inclusion, promotes equitable growth, and ensures that vital sectors receive necessary funds, balancing profitability with social objectives.

Need of Priority Lending for Commercial Banks:

  • Promotes Financial Inclusion

Priority lending ensures that underserved sectors and weaker sections of society gain access to credit, which is otherwise difficult to obtain from commercial banks. By targeting agriculture, MSMEs, housing, and education, banks help bring marginalized groups into the formal financial system. This improves access to funds for productive activities, reduces dependence on informal moneylenders, and strengthens economic participation. Financial inclusion enhances social equity, promotes savings, and encourages entrepreneurship. For commercial banks, priority lending fulfills regulatory obligations while contributing to inclusive economic growth.

  • Supports Economic Development

Priority lending channels funds to sectors that drive employment generation, infrastructure growth, and rural development. Agriculture, MSMEs, and export-oriented industries rely heavily on credit for expansion and modernization. By providing loans to these sectors, banks stimulate production, income generation, and regional development, supporting overall economic progress. In India, priority lending ensures that crucial sectors receive timely financial support, balancing profitability with national development goals. Proper implementation of priority lending promotes sustainable growth, reduces economic disparities, and strengthens the link between banking and development objectives.

  • Reduces Regional Disparities

Priority lending helps commercial banks direct funds to underdeveloped and rural regions, addressing regional imbalances in credit availability. Many areas lack access to formal financial institutions, leading to dependence on informal sources at high interest rates. By targeting these regions, banks provide credit for agriculture, small enterprises, and housing, improving local productivity and livelihoods. This ensures equitable economic growth, strengthens rural development, and reduces migration pressures on urban centers. Priority lending thus serves as a tool for balanced development, integrating remote areas into the formal economy while fulfilling social and regulatory obligations of banks.

Regulations of Priority Lending for Commercial Banks:

  • RBI Guidelines on Lending Targets

The Reserve Bank of India (RBI) mandates that commercial banks allocate a specific portion of their Adjusted Net Bank Credit (ANBC) to priority sectors. Typically, 40% of total net credit is earmarked for priority sector lending (PSL), with sub-targets for agriculture, micro and small enterprises, and weaker sections. These guidelines ensure that banks contribute to inclusive economic growth and reach underserved sectors. Banks are required to monitor, report, and comply with these targets, and failure to meet them can attract penalties or regulatory scrutiny, emphasizing disciplined and responsible lending practices.

  • Lending to Specified Sectors

RBI regulations specify eligible sectors and activities for priority lending. These include agriculture, MSMEs, housing, education, export credit, and loans to weaker sections. The guidelines also define loan limits, interest rates, and project eligibility criteria to ensure funds are utilized for genuine purposes. Banks must maintain documentation, appraisal, and monitoring systems to comply. By regulating lending activities, RBI ensures that credit reaches productive areas, minimizes misuse, and aligns bank operations with national development priorities. These regulations help banks balance profitability with social responsibility while mitigating risks associated with lending to high-priority sectors.

  • Monitoring and Reporting Compliance

Commercial banks are required to regularly monitor and report their priority sector lending achievements to the RBI. Reports include the amount lent, sectors covered, and compliance with sub-targets. Regular audits and inspections help identify deviations, assess loan quality, and ensure proper utilization. Non-compliance can result in penalties, restrictions, or adverse regulatory action, highlighting the importance of adherence. RBI monitoring ensures transparency, accountability, and effective implementation of PSL policies. This regulatory oversight safeguards public interest, strengthens financial inclusion, and ensures that commercial banks actively contribute to equitable and balanced economic growth across sectors and regions.

Challenges of Priority Lending for Commercial Banks:

  • Profitability Pressure

Priority sector loans, particularly to agriculture and micro-enterprises, often carry lower interest rates compared to commercial loans. This compresses the bank’s Net Interest Margin (NIM), a key profitability metric. Managing a large portfolio of lower-yielding assets while maintaining overall profitability is a significant challenge. Banks must carefully balance their PSL obligations with more lucrative lending to other sectors, which can divert capital from potentially higher-return investments and impact shareholder returns.

  • High Risk and Creditworthiness

A core challenge is the higher perceived risk associated with priority sector borrowers, such as small farmers and micro-businesses. These segments often lack formal income proof, collateral, and have unstable cash flows, leading to a higher probability of default and Non-Performing Assets (NPAs). Assessing their creditworthiness is difficult due to insufficient credit history, forcing banks to rely on costly and time-intensive evaluation methods, which increases operational risk and potential losses.

  • Operational Inefficiency and High Costs

Serving a vast, geographically dispersed priority sector clientele is operationally expensive. It requires an extensive branch network in rural areas, specialized staff for assessment and monitoring, and handling numerous small-ticket loans. The high transaction cost per loan makes the portfolio inherently inefficient compared to large corporate loans. While technology like mobile banking helps, the initial setup and maintenance costs for reaching remote areas further strain the bank’s operational resources.

  • Compliance and Regulatory Scrutiny

Banks face stringent compliance requirements and intense regulatory scrutiny from the RBI on meeting PSL targets and sub-targets. Falling short leads to penalties, such as depositing funds in low-interest-bearing schemes with NABARD. This regulatory pressure can sometimes lead to rushed lending or “evergreening” of loans to meet quotas, which undermines the scheme’s purpose and increases systemic risk. The complex reporting and constant monitoring make compliance a significant administrative burden.

Management Notes

Non-Performing Asset (NPA), Concepts, Meaning, Definition, Examples, Types, Causes, Effects, Importance and Circumstances

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Non-Performing Assets (NPAs) are one of the most important concepts in banking and financial accounting. Banks earn income mainly through interest on loans and advances. When borrowers fail to repay the principal amount or interest within the prescribed period, such loans become non-performing and cease to generate income for the bank. A high level of NPAs adversely affects the profitability, liquidity, and financial stability of banks. Therefore, proper identification, classification, and management of NPAs are essential for maintaining a sound banking system.

Meaning of Non-Performing Assets (NPAs)

Non-Performing Asset (NPA) is a loan or advance in respect of which the interest or installment of principal remains overdue for a specified period prescribed by the Reserve Bank of India (RBI). According to RBI guidelines, a loan account is generally classified as an NPA when interest or principal remains overdue for more than 90 days.

In simple words, an NPA is a loan that has stopped generating income for the bank because the borrower has failed to make timely payments.

Definition

According to the RBI, a Non-Performing Asset is:

“An asset, including a leased asset, becomes non-performing when it ceases to generate income for the bank and the interest and/or installment of principal remains overdue for a period of more than 90 days.”

Examples of NPAs

  • A housing loan whose installments have not been paid for more than 90 days.
  • A business loan where interest remains unpaid for over 90 days.
  • A cash credit account that remains out of order for more than 90 days.
  • A bill purchased or discounted that remains overdue for more than 90 days.

Accounting Treatment of NPAs

According to RBI guidelines:

  • Interest on NPAs is recognized only on a cash basis.
  • Adequate provisions must be made depending upon the classification of the asset.
  • NPAs are disclosed separately in the financial statements and Notes to Accounts.

Types of Non-Performing Assets (NPAs)

1. Sub-Standard Assets

A Sub-Standard Asset is an asset that has remained a Non-Performing Asset (NPA) for a period of less than or equal to 12 months. These assets exhibit well-defined credit weaknesses that may jeopardize the recovery of the loan. Although there is still a possibility of recovering the amount, the repayment capacity of the borrower has significantly deteriorated. The bank faces a higher degree of risk because the borrower has failed to make payments according to the agreed terms.

Sub-standard assets require banks to make provisions as prescribed by the Reserve Bank of India (RBI). The value of the security available against the loan and the borrower’s financial position are carefully examined to estimate the amount that may ultimately be recovered. If timely corrective measures are taken, such assets may be upgraded and become performing assets again.

Example: A bank grants a business loan of ₹20 lakh to a manufacturing company. Due to a temporary decline in sales, the company fails to pay interest and installments for more than 90 days. The loan account is classified as an NPA. Since it has remained an NPA for only six months, it is treated as a Sub-Standard Asset. The bank continues its recovery efforts and monitors the account closely to prevent further deterioration.

Sub-standard assets indicate the early stage of financial difficulty and serve as a warning signal for banks to take prompt recovery measures and strengthen credit monitoring procedures.

2. Doubtful Assets

A Doubtful Asset is an asset that has remained in the Sub-Standard category for more than 12 months. In such cases, the possibility of full recovery becomes highly uncertain, and the bank faces a significant risk of loss. The borrower’s financial position generally deteriorates further, and the value of the security may also decline over time.

The RBI requires banks to make higher provisions for doubtful assets because the chances of recovering the entire amount become increasingly remote. The extent of provisioning depends on the period for which the asset has remained doubtful and the value of the available security. Banks are required to evaluate the recoverable amount carefully and make adequate provisions in their financial statements.

Example: A company receives a term loan of ₹50 lakh from a bank. Due to continuous losses and poor management, the company fails to repay the loan. The account becomes an NPA and remains in the Sub-Standard category for more than one year. Consequently, the bank classifies the account as a Doubtful Asset. Although some machinery is available as security, the bank is uncertain about recovering the entire amount.

Doubtful assets indicate serious credit weakness and require banks to initiate strong recovery measures, including restructuring, legal action, or enforcement of securities.

3. Loss Assets

A Loss Asset is an asset that has been identified by the bank, internal auditors, external auditors, or RBI inspectors as uncollectible and of such little value that its continuance as a bankable asset is not justified. Although there may still be some salvage or recovery value, the chances of recovering the loan are extremely low. Such assets are considered practically irrecoverable.

The RBI requires banks either to write off loss assets completely or to make full provisions against them. Since the possibility of recovery is negligible, these assets represent the highest degree of credit risk and directly affect the profitability and financial position of the bank.

Example: A bank grants a loan of ₹15 lakh to a small business secured by machinery. The business closes permanently, the machinery becomes obsolete, and the borrower cannot be traced. After investigation, the bank concludes that the loan cannot be recovered. The account is therefore classified as a Loss Asset and is either written off or fully provided for in the books of accounts.

Loss assets represent the final stage of deterioration of an NPA and indicate complete or near-complete failure of recovery efforts. Proper identification and timely provisioning of such assets are essential to present a true and fair view of the financial position of the bank.

Causes of Non-Performing Assets (NPAs)
  • Poor Credit Appraisal

One of the major causes of NPAs is poor credit appraisal by banks. Before granting loans, banks are expected to assess the borrower’s financial position, repayment capacity, business prospects, and credit history. If loans are sanctioned without proper evaluation, there is a high possibility that the borrower may fail to repay the amount on time. Inadequate analysis of financial statements and insufficient verification of collateral also increase credit risk. Therefore, weak credit appraisal procedures often result in loans turning into non-performing assets and adversely affect the financial health and profitability of banks.

  • Economic Recession

Economic recession is another important cause of NPAs. During periods of economic slowdown, industries and businesses experience reduced demand, declining sales, and lower profits. As a result, many borrowers face financial difficulties and become unable to repay their loans and interest obligations. Economic recession affects almost every sector of the economy and increases the default risk of borrowers. Banks may witness a sharp rise in NPAs during such periods because borrowers’ cash flows and repayment capacities are severely affected. Therefore, adverse economic conditions are one of the major reasons behind the growth of non-performing assets.

  • Industrial Sickness

Industrial sickness refers to the poor financial condition of industrial units caused by continuous losses, outdated technology, inefficient management, or declining market demand. Sick industries often fail to generate sufficient income to meet their financial obligations, including repayment of bank loans. As a result, the loans granted to such industries become non-performing assets. Industrial sickness not only affects the borrowers but also creates significant problems for banks by increasing their bad debts and provisioning requirements. Therefore, the financial failure of industrial units is an important factor contributing to the growth of NPAs.

  • Diversion or Misuse of Funds

Many borrowers divert or misuse the funds borrowed from banks for purposes other than those for which the loans were sanctioned. Instead of investing the money in productive activities, borrowers may use it for speculative investments, personal expenses, or unrelated businesses. Such misuse affects the profitability and cash flow of the borrowing entity and reduces its ability to repay the loan. Consequently, the loan account becomes irregular and eventually turns into a non-performing asset. Therefore, diversion and misuse of borrowed funds are significant causes of NPAs in the banking sector.

  • Wilful Default by Borrowers

Wilful default occurs when borrowers have the capacity to repay their loans but deliberately avoid making payments. Some borrowers intentionally delay repayments, divert assets, or refuse to honour their financial commitments despite having adequate resources. Such intentional defaults adversely affect the recovery performance of banks and increase the level of NPAs. Wilful defaulters also create liquidity problems for banks and reduce their ability to provide credit to other deserving borrowers. Therefore, deliberate non-payment of loans is one of the major causes of the growing problem of non-performing assets.

  • Inefficient Management of Borrowing Units

The success of a business largely depends on the efficiency and competence of its management. Poor managerial decisions, inadequate planning, lack of financial discipline, and ineffective utilization of resources often result in business losses and financial distress. Inefficient management reduces the earning capacity of the borrowing unit and affects its ability to repay bank loans. Consequently, loan accounts become overdue and are eventually classified as non-performing assets. Therefore, poor management practices in borrowing organizations constitute an important cause of NPAs in the banking sector.

  • Natural Calamities and Unforeseen Events

Natural calamities such as floods, earthquakes, droughts, cyclones, and pandemics can significantly affect the repayment capacity of borrowers. Such unforeseen events may destroy businesses, agricultural activities, and productive assets, resulting in substantial financial losses. Borrowers affected by these events often find it difficult to generate income and repay their loans. Consequently, banks experience an increase in non-performing assets, especially in regions severely affected by natural disasters. Therefore, natural calamities and other unforeseen circumstances are important external factors contributing to the growth of NPAs.

  • Political and Policy Changes

Frequent changes in government policies, taxation, regulations, and economic measures can adversely affect businesses and industries. Sudden policy changes may increase production costs, reduce profitability, or create uncertainty in the business environment. Borrowers operating in affected sectors may face financial difficulties and become unable to repay their loans. Political instability and changes in government policies can therefore contribute to an increase in loan defaults and non-performing assets. Hence, political and policy-related factors are also important causes of NPAs in the banking system.

Effects of Non-Performing Assets (NPAs)
  • Reduction in Profitability

One of the most significant effects of NPAs is the reduction in the profitability of banks. When loans become non-performing, banks stop earning interest income from such assets. At the same time, banks are required to make provisions for doubtful and bad debts according to RBI guidelines. These provisions are charged to the Profit and Loss Account, thereby reducing net profits. Lower profitability affects the bank’s financial performance, dividend-paying capacity, and ability to expand its operations. Therefore, a high level of NPAs has a direct and adverse impact on the earnings and profitability of banking institutions.

  • Decline in Liquidity

NPAs adversely affect the liquidity position of banks. Loans and advances constitute a major portion of the assets of banks and are expected to generate regular cash inflows through repayment of principal and interest. When borrowers fail to make payments, the expected cash inflows do not materialize, resulting in a shortage of funds. Consequently, banks may face difficulties in meeting their obligations towards depositors and other creditors. A decline in liquidity also restricts the bank’s ability to provide new loans and meet operational requirements. Therefore, NPAs significantly weaken the liquidity position of banks.

  • Increase in Provisioning Requirements

The RBI requires banks to make adequate provisions against non-performing assets depending on their classification as sub-standard, doubtful, or loss assets. As the level of NPAs increases, the amount required to be set aside as provisions also rises. These provisions reduce the profits available for distribution and weaken the financial position of banks. High provisioning requirements also reduce the funds available for productive lending and investment activities. Therefore, one of the major effects of NPAs is the increased burden of provisioning, which adversely affects the profitability and operational efficiency of banking institutions.

  • Reduction in Lending Capacity

A high level of NPAs reduces the lending capacity of banks. Since a significant portion of the bank’s funds becomes blocked in unrecovered loans, fewer resources remain available for granting fresh loans and advances. Banks may also adopt a cautious approach toward lending due to the fear of further defaults. Reduced lending adversely affects business expansion, industrial growth, and economic development because borrowers face difficulties in obtaining credit. Therefore, NPAs not only affect the individual bank but also have broader implications for the economy by restricting the flow of credit.

  • Increase in Cost of Funds

NPAs increase the overall cost of funds for banks. Since a portion of loans remains unrecovered, banks continue to incur interest expenses on deposits and borrowings without receiving corresponding income from non-performing assets. To compensate for these losses, banks may increase lending rates or seek additional funds at higher costs. Higher costs reduce competitiveness and affect the profitability of banking operations. Therefore, the existence of a large amount of NPAs increases the cost burden on banks and adversely affects their financial performance.

  • Adverse Impact on Shareholders and Investors

The growth of NPAs adversely affects shareholders and investors. Lower profitability due to NPAs reduces earnings per share and limits the payment of dividends. Investors often perceive banks with high NPAs as financially weak and risky institutions. Consequently, the market value of the bank’s shares may decline, and investor confidence may be adversely affected. A poor financial image also makes it difficult for banks to raise additional capital from the market. Therefore, NPAs have significant negative consequences for shareholders and investors.

  • Weakening of the Banking System

A high level of NPAs weakens the overall banking system. When several banks experience substantial loan defaults, their profitability, liquidity, and capital adequacy are adversely affected. Weak banks may become incapable of supporting economic growth through lending activities. In extreme situations, persistent NPAs may even threaten the solvency and stability of financial institutions. Therefore, NPAs pose a serious challenge to the soundness and efficiency of the banking system and require effective management and regulatory supervision.

  • Adverse Impact on Economic Development

The effects of NPAs extend beyond individual banks and influence the overall economy. High NPAs reduce the availability of credit for productive sectors such as agriculture, industry, and infrastructure. Limited access to finance restricts investment, employment generation, and business expansion. Moreover, government resources may be required to recapitalize weak banks, increasing the financial burden on the economy. Therefore, a high level of NPAs adversely affects economic growth and hampers the efficient allocation of financial resources in the country.

Importance of Managing Non-Performing Assets (NPAs)
  • Improves Profitability

Effective management of NPAs helps banks improve their profitability. When non-performing loans are recovered or reduced, banks start receiving interest and principal repayments regularly. Lower NPAs also reduce the need for heavy provisioning, thereby increasing net profits. Improved profitability strengthens the financial position of banks and enables them to expand their operations. Higher profits also increase the confidence of shareholders and investors. Therefore, proper management of NPAs is essential for maintaining stable earnings and ensuring the long-term financial success of banking institutions.

  • Protects Depositors’ Funds

Banks primarily operate with funds deposited by the public. If a large amount of loans becomes non-performing, the safety of depositors’ money may be affected. Effective management of NPAs ensures timely recovery of loans and prevents unnecessary losses. This strengthens the financial stability of banks and safeguards the interests of depositors. Public confidence in the banking system depends largely on the safety of deposits and the soundness of banks. Therefore, managing NPAs is important because it protects depositors’ funds and maintains trust in banking institutions.

  • Enhances Liquidity

NPAs block a significant portion of the funds of banks because the expected repayments are not received on time. Proper management and recovery of non-performing assets improve cash inflows and strengthen the liquidity position of banks. Improved liquidity enables banks to meet their obligations to depositors and creditors and also provides funds for new lending opportunities. Adequate liquidity is essential for the smooth functioning of banking operations. Therefore, effective management of NPAs plays an important role in maintaining a healthy liquidity position.

  • Increases Lending Capacity

When NPAs are reduced, the funds blocked in bad loans become available for productive lending activities. Banks can use these recovered funds to provide fresh loans and advances to businesses, industries, and individuals. Increased lending capacity promotes business expansion and contributes to economic development. On the other hand, high NPAs restrict the ability of banks to extend credit. Therefore, proper management of NPAs is important because it enhances the lending capacity of banks and improves the flow of credit in the economy.

  • Strengthens Financial Stability

A lower level of NPAs contributes significantly to the financial stability of banks. Banks with sound asset quality are better equipped to withstand economic challenges and financial crises. Effective management of NPAs improves capital adequacy, reduces credit risk, and strengthens the overall financial position of banks. Financially stable banks are more capable of fulfilling their obligations and supporting economic growth. Therefore, one of the major importance of managing NPAs is that it strengthens the stability and resilience of the banking system.

  • Improves Investor Confidence

Investors and shareholders prefer to invest in banks that maintain low levels of NPAs and demonstrate sound financial performance. Effective management of NPAs improves profitability, strengthens financial statements, and enhances the market reputation of banks. As a result, investor confidence increases, and banks find it easier to raise additional capital from the market. Strong investor confidence also contributes to higher market valuation and better growth prospects. Therefore, managing NPAs is important for maintaining the trust and confidence of investors and shareholders.

  • Ensures Compliance with Regulatory Requirements

The Reserve Bank of India has prescribed various norms regarding the recognition, classification, and provisioning of NPAs. Effective management of non-performing assets helps banks comply with these regulatory requirements and avoid penalties or supervisory actions. Proper compliance also improves transparency and ensures that financial statements present a true and fair view of the bank’s financial position. Therefore, managing NPAs is important because it enables banks to meet regulatory standards and maintain financial discipline.

  • Promotes Economic Growth

Banks play a crucial role in the economic development of a country by providing financial assistance to various sectors. Effective management of NPAs improves the financial health of banks and increases the availability of credit for productive activities. Greater lending to businesses and industries promotes investment, employment generation, and economic growth. Conversely, high NPAs restrict credit flow and hinder development. Therefore, managing NPAs is important not only for banks but also for the overall growth and stability of the economy.

Circumstances Leading to Non-Performing Assets (NPAs)

  • Economic Recession and Slowdown

Economic recession is one of the major circumstances leading to NPAs. During an economic slowdown, the demand for goods and services declines significantly. Businesses experience lower sales, reduced profits, and cash flow problems. As a result, borrowers find it difficult to repay their loans and interest obligations to banks. Industries such as manufacturing, real estate, and construction are particularly affected during recessionary periods. Unemployment and reduced income levels also affect individual borrowers and increase loan defaults. Consequently, a large number of performing assets become non-performing assets. Therefore, economic recession adversely affects the repayment capacity of borrowers and contributes significantly to the growth of NPAs in the banking sector.

  • Industrial Sickness and Business Failure

Industrial sickness refers to the poor financial condition of industries caused by continuous losses, outdated technology, inefficient management, or declining demand. Sick industries fail to generate sufficient income to meet their financial obligations, including repayment of bank loans. Business failures result in closure of operations, loss of revenue, and inability to repay principal and interest amounts. Such circumstances increase the number of loan defaults and adversely affect the financial position of banks. When industries become financially weak, the loans granted to them often turn into non-performing assets. Therefore, industrial sickness and business failure are important circumstances that lead to the creation of NPAs.

  • Poor Credit Appraisal by Banks

Poor credit appraisal is another significant circumstance leading to NPAs. Before granting loans, banks are expected to evaluate the borrower’s financial position, repayment capacity, and business prospects. If banks fail to conduct proper credit analysis, loans may be granted to borrowers who are financially weak or incapable of repayment. Inadequate verification of documents, overestimation of business potential, and failure to assess risks can result in loan defaults. Poor credit appraisal increases the possibility of bad debts and affects the quality of bank assets. Therefore, improper evaluation of borrowers at the time of sanctioning loans is an important reason for the growth of NPAs.

  • Diversion or Misuse of Borrowed Funds

Borrowers sometimes use loan funds for purposes other than those for which the loans were sanctioned. Instead of investing the money in productive activities, they may divert it to speculative investments, personal expenses, or unrelated businesses. Such misuse of funds reduces the profitability and cash flow of the business and weakens the borrower’s ability to repay the loan. Consequently, loan accounts become irregular and are eventually classified as non-performing assets. Diversion of funds also indicates poor financial discipline and increases the credit risk faced by banks. Therefore, misuse of borrowed funds is a major circumstance contributing to the growth of NPAs.

  • Wilful Default by Borrowers

Wilful default occurs when borrowers deliberately avoid repayment despite having the financial capacity to repay their loans. Some borrowers intentionally withhold payments, divert assets, or refuse to honour their commitments to banks. Such deliberate defaults increase the burden of bad debts and adversely affect the recovery performance of banks. Wilful defaulters create liquidity problems and reduce the availability of funds for productive lending activities. Since these borrowers intentionally avoid repayment, recovery becomes difficult and time-consuming. Therefore, wilful default is one of the major circumstances leading to the increase in non-performing assets in the banking system.

  • Inefficient Management and Poor Business Decisions

The success of a business largely depends on the efficiency and competence of its management. Poor managerial decisions, lack of planning, excessive borrowing, and inefficient utilization of resources often result in business losses. Inefficient management reduces the earning capacity of the business and affects its ability to repay bank loans. Poor financial management may lead to declining sales, increased costs, and liquidity problems. Consequently, the business becomes unable to meet its financial obligations and the loan account turns into a non-performing asset. Therefore, inefficient management and poor business decisions are important circumstances responsible for the growth of NPAs.

  • Natural Calamities and Unforeseen Events

Natural disasters such as floods, earthquakes, droughts, cyclones, and pandemics can significantly affect the repayment capacity of borrowers. Such unforeseen events may destroy businesses, agricultural activities, and productive assets, resulting in severe financial losses. Borrowers affected by these events often face difficulties in generating income and repaying their loans. The problem is particularly serious in the case of agricultural borrowers whose livelihood depends heavily on weather conditions. Consequently, banks experience an increase in non-performing assets in affected regions. Therefore, natural calamities and unforeseen events are important external circumstances leading to the creation of NPAs.

  • Changes in Government Policies and Regulations

Frequent changes in government policies, taxation, trade regulations, and economic measures can adversely affect businesses and industries. Sudden policy changes may increase production costs, reduce profitability, or create uncertainty in the business environment. Borrowers operating in affected sectors may experience financial difficulties and become unable to repay their loans. Changes in import-export policies, environmental regulations, or tax laws may also disrupt business operations and reduce income. Consequently, banks may witness an increase in loan defaults and non-performing assets. Therefore, changes in government policies and regulations are important circumstances contributing to the growth of NPAs.

Management Notes

Letters of Credit, Functions, Types, Process

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Letter of Credit (LC) is a written commitment issued by a bank on behalf of a buyer, guaranteeing payment to a seller upon the fulfillment of specific terms and conditions—usually the delivery of goods or services. It acts as a risk-reducing financial instrument in international trade, assuring the exporter that payment will be made if the shipping documents comply with the terms mentioned in the LC. It is commonly used when buyers and sellers are in different countries and do not know each other well.

The bank issuing the LC (issuing bank) works with the seller’s bank (advising or negotiating bank) to verify documents such as the bill of lading, invoice, insurance papers, and inspection certificates. Once the seller submits compliant documents, the bank releases the payment. Letters of Credit help eliminate credit risk, currency issues, and trust gaps, making them essential in global trade for ensuring timely and guaranteed payments between unfamiliar parties in cross-border transactions.

Functions of Letters of Credit:

  • Ensures Payment Security in Trade

The primary function of a Letter of Credit is to guarantee payment to the seller upon fulfillment of specific terms. It eliminates the risk of buyer default by shifting the payment responsibility to a reliable bank. Once the seller submits the required documents proving shipment, the bank is obligated to pay, regardless of the buyer’s financial status. This function provides confidence to exporters, encouraging international trade by ensuring that sellers are paid promptly and securely.

  • Builds Trust Between Unfamiliar Parties

In international or long-distance trade, buyers and sellers often operate across borders without prior relationships. Letters of Credit act as trust-building instruments, assuring the seller that the buyer has a bank backing their payment. It also assures the buyer that payment will only be made if the seller complies with the agreed terms. This mutual protection creates a neutral and legally binding mechanism, reducing hesitation in cross-border deals and enabling smoother global commerce.

  • Reduces Credit Risk for Sellers

Letters of Credit mitigate credit risk by transferring it from the buyer to a financial institution. The seller does not have to depend solely on the buyer’s creditworthiness. Instead, the seller relies on the issuing bank’s obligation to pay. This reduces the fear of non-payment or delayed payment, especially in cases where the buyer is in a politically or economically unstable country. For exporters, this function adds a level of financial security that supports international business expansion.

  • Facilitates Financing for Trade

LCs also function as a financing tool for both exporters and importers. Sellers can use the LC as collateral to obtain pre-shipment or post-shipment finance from their bank. Importers may get credit terms through a Usance LC, allowing deferred payment. This facilitates better cash flow management for both parties. LCs also enable traders to structure complex deals, such as transferable or back-to-back credits, helping intermediaries and suppliers secure funding based on assured future payments.

  • Ensures Compliance Through Document Control

A key function of LCs is to ensure that trade documentation is complete and accurate before payment is released. The seller must provide documents like bills of lading, invoices, insurance certificates, and inspection reports, all matching the LC terms. The bank verifies these meticulously before making payment. This function enforces discipline and legal compliance, protecting both the buyer and the bank, and ensuring that goods are shipped as agreed before money changes hands.

  • Encourages International Trade Growth

By reducing payment uncertainty, enforcing trade conditions, and providing financial assurance, LCs play a crucial role in boosting international trade. They make it easier for companies to do business with new partners across borders, overcoming language, legal, and currency barriers. The use of LCs fosters smoother global transactions and promotes economic integration. For many businesses, especially exporters in developing economies, LCs serve as critical enablers of trade, ensuring business continuity and market expansion.

Types of Letters of Credit:

  • Revocable Letter of Credit

Revocable Letter of Credit allows the issuing bank to modify or cancel the LC at any time without prior notice to the beneficiary (seller). This type offers minimal protection to the seller, as the guarantee can be withdrawn even after shipment. Due to its high risk for exporters, revocable LCs are rarely used in international trade. They may be suitable only for domestic or highly trusted transactions, where the buyer and seller have a long-standing relationship.

  • Irrevocable Letter of Credit

An Irrevocable LC cannot be altered or cancelled without the agreement of all parties involved, including the beneficiary. It provides strong security to the seller, as the issuing bank is obligated to honor payment if compliant documents are submitted. Most LCs used in global trade today are irrevocable. This type ensures that sellers can ship goods with confidence, knowing that payment is guaranteed, provided they meet all terms specified in the LC.

  • Confirmed Letter of Credit

Confirmed Letter of Credit includes a second guarantee from another bank—usually the advising bank—along with the issuing bank. This added confirmation is requested when the seller does not trust the issuing bank or when the buyer is in a country with political or economic instability. The confirming bank takes on the responsibility to pay, even if the issuing bank defaults. This provides an additional layer of security to exporters and is often used in high-risk markets.

  • Unconfirmed Letter of Credit

An Unconfirmed LC is only backed by the issuing bank, with no obligation on the advising bank. If the issuing bank fails to honor the payment, the seller must take legal steps against it. This is more common when both buyer and issuing bank are based in stable economies and the seller is confident in their credibility. While it involves lower costs, it offers less security than a confirmed LC, making it less attractive in high-risk transactions.

  • Sight Letter of Credit

Sight LC is payable immediately upon presentation of compliant documents. Once the seller submits the required documents to the advising bank and they are verified, payment is made “at sight”, meaning on the spot or within a short period (typically 2–7 days). This is beneficial for sellers who need quick access to funds and is commonly used in trade where goods are shipped immediately, and cash flow is essential for ongoing business operations.

  • Usance (Deferred Payment) Letter of Credit

Usance LC or Deferred Payment LC allows for payment to be made at a future date after the documents are submitted. The time period (30, 60, or 90 days) is agreed upon in advance. This benefits the buyer by providing short-term credit to arrange funds, while the seller gets assurance of future payment from the issuing bank. It is ideal for large transactions, where buyers need time to resell goods before making full payment.

  • Transferable Letter of Credit

Transferable LC allows the original beneficiary (usually a middleman or trader) to transfer a portion or full value of the credit to another party (like a supplier). This is useful in cases where the beneficiary is not the actual manufacturer but wants to fulfill the order through a third party. It facilitates back-to-back trade deals and enables financing of transactions without upfront capital. Only LCs clearly marked as “transferable” can be legally passed on to others.

  • Back-to-Back Letter of Credit

Back-to-Back LC involves two separate LCs: the first is issued in favor of an intermediary (trader), and the second is issued by the intermediary’s bank to the final supplier, using the first LC as security. This type is used when the intermediary doesn’t have enough credit or capital but wants to facilitate the transaction between buyer and supplier. It supports complex trade chains and allows smooth execution of orders without involving direct financial exposure.

Process of Letters of Credit:

1. Buyer and Seller Agree on LC Terms

The process begins when the buyer and seller agree to use a Letter of Credit as the payment method in their contract. They define the LC terms, including the amount, shipment date, required documents, and conditions for payment. The buyer then contacts their bank (issuing bank) to initiate the LC. This agreement ensures both parties are aware of their obligations and that the seller is protected against payment risks, especially in international trade.

2. Buyer Requests LC from Issuing Bank

The buyer approaches their bank and formally requests the issuance of the LC in favor of the seller (beneficiary). The issuing bank reviews the buyer’s creditworthiness, may require a margin or security, and then issues the LC. The LC outlines all terms such as amount, expiry, document requirements, and conditions for payment. It serves as a payment guarantee from the issuing bank, giving the seller assurance that payment will be made upon fulfilling the conditions.

3. Issuing Bank Sends LC to Advising Bank

Once the LC is issued, the issuing bank forwards it to the seller’s bank (advising bank), usually located in the seller’s country. The advising bank authenticates the LC, ensuring its legitimacy, and notifies the seller about the receipt of the LC. It does not take on any payment obligation but acts as an intermediary for communication. This step assures the seller that the payment is backed by a reputable financial institution and that trade can proceed safely.

4. Seller Ships Goods and Submits Documents

The seller, after receiving and reviewing the LC, ships the goods as per the agreed terms. They then prepare and submit the required shipping and commercial documents (e.g., invoice, bill of lading, packing list, insurance certificate) to the advising or negotiating bank. These documents must strictly comply with the LC terms. This step ensures that the seller has fulfilled their contractual obligations and is now eligible to receive payment upon document verification.

5. Advising Bank Forwards Documents to Issuing Bank

The advising or negotiating bank checks the documents for discrepancies. If everything is in order, it forwards the documents to the issuing bank for final scrutiny. Some advising banks may also make payment or advance funds if they confirm the LC. The issuing bank then verifies whether the documents meet all the LC conditions. If compliant, the bank proceeds to make or authorize the payment to the seller, ensuring secure transfer of funds.

6. Payment is Made and Buyer Receives Goods

Upon successful verification, the issuing bank releases payment to the seller through the advising or negotiating bank. The issuing bank then forwards the original shipping documents to the buyer, who uses them to clear the goods at port or customs. The transaction is now complete. This final step ensures that the seller is paid and the buyer gains access to the goods, fulfilling the purpose of the Letter of Credit as a secure payment method in international trade.

Management Notes

Kinds of Bank Lending Facilities

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Credit Facility is an agreement with bank that enables a person or organization to be taken credit or borrow money when it is needed. All types of credit facilities may broadly be classified into two groups on the basis of Funding:

  • Fund Base Credit
  • Non Fund Base Credit

Fund Base Credit is the any credit facility which involves direct outflow of Bank’s fund to the borrower. Various types of it are as follows:

  1. Loan

It refers to credit facility that is repayable in a definite period. (e.g. Term Loan, Demand Loan)

  1. Cash Credit

It refers to credit facility in which borrower can borrow any time with in the agreed limit for certain period for their working capital need. It secured by way of Hypothecation of Stock (goods) and Debtors and all other current Assets of the business generated during the course of business. Cash credit can also be secured by way of mortgage of immovable properties (as collateral security).

  1. Over Draft

An overdraft allows a current account holder to withdraw in excess of their credit balance up to a sanctioned limit. It secured by way of Mortgage of immovable properties and pledge of F.D., Bonds, Shares securities, Gold & silver and any physical asset and Hypothecation of Stock and Debtors and all other current Assets of the business generated during the course of business.

  1. Packing Credit

It is a credit facility which sanctioned to an exporter in the Pre-Shipment stage. Such credit facilitates the exporter to purchase raw materials at competitive rates and manufacture or produce goods according to the requirement of the buyer and organize to have it packed for onward export. It secured by way of Hypothecation of Stock of goods and Debtors and all other current Assets of the business generated during the course of business.

  1. Some other fund based credit facilities are Bill Discounted, Bill Purchased, Advance against hypothecation of Vehicles (Transport Loan), House Building Loan, Consumer Loan, Agriculture Loan, Farming, Non Farming, Consortium Loan, Lease Financing, Hire Purchase, Import Financing, Loan against Imported Merchandise (LIM), Payment against Document (PAD).

Non Fund Base credit is a credit facility where there is no involvement of direct outflow of Bank’s fund on account of borrower rather the outflow of Bank’s fund on account of Third party on behalf of borrower.

Types of it are as follow:

  1. Letter Of Credit

When a buyer or importer wants to purchase goods from an unknown seller or exporter. He can take assistance of bank in such buying or importing transactions.

Bank issues a LETTER OF CREDIT in addressed to the supplier or exporter after it, supplier or exporter will supply the goods to such unknown buyer or importer. A signed Invoice with Letter Of Credit is presented to the bank of buyer/importer and the payment is made to the seller/exporter DIRECTLY by the bank.

  1. Bank Guarantee

It is a guarantee issued by a banker that, in case of an occurrence or non-occurrence of a particular event, the bank guarantees to fulfilled the loss of money as stipulated in the contact. It may of various types like Financial Guarantees, Performance Guarantees and Deferred Payment Guarantee.

  1. Buyer Credit

It is the credit availed by an Importer from overseas lenders (i.e. Banks & Financial Institutions) for payment against his imports. The overseas bank usually lends the Importer based on letter of credit, bank guarantee issued by the importer bank.

  1. Suppliers Credit

Under such credit facility an exporter extends credit to a foreign importer to finance his purchase. Usually the importer pays a portion of the contact value in cash and issues a Promissory note as evidence of his obligation to pay the balance over a period of time. The exporter thus accepts a deferred payment from the importer and may be able to obtain cash payment by discounting or selling such promissory note created with his bank.

Management Notes

Principles of Bank Lending

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Bank lending is one of the primary functions of banks in India, where financial institutions provide loans and advances to individuals, businesses, and organizations to support economic growth. Lending involves risk, so banks follow established principles to ensure safety, profitability, and liquidity of funds. These principles guide the evaluation of borrowers, loan purposes, repayment capacity, and security. Adhering to these principles helps banks avoid defaults, maintain financial stability, and sustain trust with depositors. In India, the Reserve Bank of India (RBI) provides regulatory oversight to ensure banks follow sound lending practices that support economic development responsibly.

1. Principle of Safety

The principle of safety is the foremost principle of bank lending, ensuring that the principal amount lent is protected. Banks must evaluate the borrower’s creditworthiness, financial health, and repayment capacity before sanctioning loans. Safety is often ensured through adequate collateral, guarantees, and proper documentation. For example, secured loans backed by property or fixed deposits reduce the risk of loss. Banks also verify the purpose of the loan to prevent misuse of funds. Safety ensures that banks maintain their financial stability and protect the interests of depositors. In India, safety is emphasized through RBI guidelines, internal credit appraisal systems, and regular monitoring. Neglecting this principle can lead to non-performing assets (NPAs), financial loss, and reputational damage. By adhering to the safety principle, banks can lend responsibly while contributing to economic growth and maintaining trust in the banking system.

2. Principle of Liquidity

The principle of liquidity ensures that banks can recover the lent funds quickly when required. Loans must be structured to balance the bank’s cash flow requirements with the borrower’s repayment schedule. Short-term loans, like working capital finance, provide immediate liquidity, while medium- and long-term loans, such as term loans for infrastructure projects, are planned carefully to maintain liquidity. Banks assess repayment schedules, collateral realizability, and borrower’s cash flow to ensure funds are not locked for an extended period. Proper liquidity management allows banks to meet withdrawal demands, regulatory requirements, and emergency funding needs. In India, liquidity is closely monitored by the RBI through Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) requirements. Loans that are difficult to liquidate or poorly monitored increase risk, so liquidity is a critical principle to maintain solvency, operational efficiency, and financial stability in the banking system.

3. Principle of Profitability

The principle of profitability ensures that bank lending generates reasonable returns through interest and fees while maintaining safety. Banks must assess the risk-return profile of each loan, evaluating the borrower’s financial position, project viability, and market conditions. Loans are priced with interest rates that cover the cost of funds, operational expenses, and expected risk. Profitability is balanced with safety; high returns should not compromise the security of the principal. In India, profitability is also affected by RBI directives on priority sector lending, interest rate caps, and lending limits. Proper appraisal, risk management, and portfolio diversification help banks maximize returns. By adhering to the profitability principle, banks sustain growth, pay interest to depositors, and reinvest in the economy. Neglecting profitability may lead to unviable lending, operational losses, or insolvency, making this principle critical for long-term financial health.

4. Principle of Purpose

The principle of purpose requires that bank loans are used for genuine and productive purposes. Funds should not be diverted to speculative or illegal activities, as misuse increases the risk of default and legal complications. For example, loans intended for business expansion, agriculture, or housing must be utilized for the stated purpose. Banks verify borrower intentions through project proposals, financial statements, and monitoring mechanisms. Purpose-oriented lending also aligns with economic development goals, such as supporting agriculture, small businesses, and infrastructure projects in India. RBI guidelines emphasize priority sector lending to ensure funds reach essential sectors. Adherence to this principle protects the bank’s interests, enhances loan recovery rates, and strengthens public trust. Loans granted without a clear, productive purpose can lead to non-performing assets, financial losses, and reputational damage, highlighting the importance of lending for legitimate, planned, and productive uses.

5. Principle of Diversification

The principle of diversification emphasizes that banks should avoid concentrating loans in a single sector, region, or borrower, reducing exposure to risk. By lending to multiple borrowers across industries and regions, banks can manage defaults more effectively. For example, if one sector suffers an economic downturn, diversified loans in other sectors ensure that the bank’s overall portfolio remains stable. Diversification also includes spreading risk between short-term and long-term loans, secured and unsecured advances, and priority and non-priority sectors. In India, RBI guidelines on sectoral exposure limits and priority sector lending reinforce diversification. Proper diversification minimizes financial instability, prevents large-scale losses, and ensures consistent profitability. Banks that ignore this principle risk overexposure to high-risk sectors or borrowers, which can lead to non-performing assets, liquidity crises, and reputational damage, making diversification a cornerstone of prudent lending practices.

6. Principle of Security

The principle of security refers to the requirement of collateral or assets offered by the borrower against the loan. Security acts as a protection for the bank in case the borrower fails to repay the loan. Banks generally accept tangible securities such as land, buildings, machinery, gold, stocks, or government securities. The value of security should be adequate, stable, and easily marketable. However, security alone does not guarantee repayment; it only serves as a secondary source of recovery. By following the principle of security, banks reduce credit risk and safeguard their funds against possible losses.

7. Principle of National Interest

The principle of national interest requires banks to align their lending activities with the economic and social objectives of the country. Banks play a vital role in economic development by providing credit to priority sectors such as agriculture, small-scale industries, exports, education, and weaker sections of society. In India, banks follow government and RBI guidelines while lending. Even if some sectors offer lower profitability, banks support them for national growth and employment generation. This principle ensures balanced regional development, financial inclusion, and economic stability. Lending in national interest strengthens the overall economy and promotes social welfare.

8. Principle of Character (Creditworthiness of Borrower)

The principle of character refers to the honesty, integrity, and reputation of the borrower. Banks assess the borrower’s credit history, past repayment behavior, business ethics, and personal conduct before granting loans. A borrower with strong character is more likely to honor repayment commitments even during financial difficulties. Banks rely on credit reports, references, and banking records to judge character. While security and income are important, character plays a crucial role in lending decisions. This principle reduces moral risk and ensures responsible borrowing. Lending to trustworthy borrowers enhances loan recovery and strengthens long-term banker–customer relationships.

Management Notes

Dishonor of Cheques, Reasons for Dishonour of Cheques, Grounds for Dishonor of Cheques

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A cheque is an important negotiable instrument used for making payments. When a cheque is presented to the bank for payment and the bank refuses to honour it, the cheque is said to be dishonoured. Dishonour of cheques has serious legal consequences under Indian law.

Meaning of Dishonour of Cheque

Dishonour of cheque occurs when a cheque presented for payment is returned unpaid by the bank. This may happen due to insufficient funds in the drawer’s account or other technical or legal reasons. Dishonour affects the credibility of the drawer and may result in civil as well as criminal liability.

Legal Provision (Section 138)

Dishonour of cheques is governed by Section 138 of the Negotiable Instruments Act, 1881. This section provides that dishonour of a cheque for insufficiency of funds or if it exceeds the arrangement made with the bank is a criminal offence, punishable with imprisonment or fine or both.

Reasons for Dishonour of Cheque

A cheque is dishonoured when the bank refuses to make payment on presentation. Dishonour may occur due to financial, technical, or legal reasons. The following are the major reasons for dishonour of a cheque

  • Insufficient Funds

Insufficient funds is the most common reason for dishonour of a cheque. It occurs when the balance in the drawer’s bank account is less than the amount mentioned in the cheque. In such cases, the bank returns the cheque unpaid. Dishonour due to insufficient funds attracts criminal liability under Section 138 of the Negotiable Instruments Act, 1881, provided other legal requirements are fulfilled.

  • Exceeds Arrangement with Bank

A cheque is dishonoured when it exceeds the overdraft or credit limit sanctioned by the bank. Even if some balance is available, payment will be refused if it goes beyond the agreed arrangement. This reason is treated at par with insufficient funds under Section 138, as the drawer fails to honour his commitment within the agreed banking limits.

  • Signature Mismatch

A cheque may be dishonoured if the signature of the drawer does not match the specimen signature available with the bank. Banks strictly verify signatures to prevent fraud. Even minor differences in signature can lead to dishonour. In such cases, dishonour usually arises due to technical reasons rather than financial incapacity of the drawer.

  • Post-Dated Cheque Presented Early

When a post-dated cheque is presented to the bank before the date mentioned on it, the bank will dishonour it. A post-dated cheque becomes valid only on or after the specified date. Premature presentation makes the cheque invalid, resulting in dishonour. Such dishonour does not generally attract penal provisions under Section 138.

  • Account Closed

If the drawer has closed his bank account before the cheque is presented for payment, the cheque will be dishonoured. Courts have held that dishonour due to “account closed” is equivalent to insufficiency of funds. Therefore, it attracts liability under Section 138, as closing the account indicates intention to avoid payment.

  • Stop Payment Instructions

A cheque may be dishonoured if the drawer issues stop payment instructions to the bank. Even though sufficient funds may be available, the bank refuses payment as per the drawer’s instructions. Dishonour due to stop payment may still attract Section 138 liability if the cheque was issued for a legally enforceable debt.

  • Stale or Outdated Cheque

A cheque becomes stale if it is presented after the expiry of its validity period, which is usually three months from the date of issue. Banks do not honour stale cheques, leading to dishonour. Such dishonour is technical in nature and does not generally result in criminal liability under Section 138.

  • Material Alteration in Cheque

A cheque is dishonoured if it contains material alterations such as changes in date, amount, or payee’s name without proper authentication by the drawer. Material alteration makes the cheque invalid. Banks dishonour such cheques to prevent fraud and misuse, as altered cheques lack legal validity.

Punishment for Dishonour of Cheque

Under Section 138, punishment may include:

  • Imprisonment up to 2 years, or

  • Fine up to twice the amount of the cheque, or

  • Both imprisonment and fine

The court may also order compensation to the complainant.

Reasons for Dishonour of Cheques

  • Insufficient Funds

Insufficient funds is the most common reason for dishonour of cheques. It occurs when the balance available in the drawer’s bank account is less than the amount mentioned on the cheque. In such a situation, the drawee bank cannot honour the cheque and returns it unpaid. This reason reflects poor financial discipline or negligence on the part of the drawer. Dishonour due to insufficient funds is a serious matter in banking and may attract penal action under Section 138 of the Negotiable Instruments Act, 1881. Banks strictly monitor such cases to protect depositors’ money.

  • Mismatch of Signature

A cheque is dishonoured when the signature of the drawer on the cheque does not match the specimen signature recorded with the bank. Banks are legally bound to verify signatures to prevent forgery and unauthorized transactions. Even small variations in handwriting, use of initials, or shaky signatures due to illness can lead to dishonour. This reason highlights the importance of consistency in signing cheques. Signature mismatch protects the bank from fraudulent payments but may inconvenience customers if signatures are not carefully maintained.

  • Overwriting or Alteration

Cheques containing overwriting, erasures, or alterations are often dishonoured by banks. Changes in date, amount, or name of the payee without proper authentication raise suspicion about the genuineness of the cheque. Banks require that any correction made on a cheque must be clearly confirmed by the drawer’s full signature. Dishonour due to alterations helps maintain the integrity of negotiable instruments and prevents misuse. This reason emphasizes careful and error-free filling of cheques by account holders.

  • Post-Dated or Stale Cheque

A cheque may be dishonoured if it is either post-dated or stale. A post-dated cheque is one that bears a future date and cannot be paid before that date. A stale cheque is one presented after the expiry of its validity period, generally three months from the date of issue. Banks follow strict rules regarding the validity of cheques to ensure lawful payment. Dishonour in such cases is procedural and not related to the financial position of the drawer.

  • Stop Payment Instructions

Dishonour may occur when the drawer gives a stop payment instruction to the bank before the cheque is presented for payment. This instruction directs the bank not to honour a specific cheque. Stop payment may be issued due to loss of cheque, dispute with the payee, or error in issuance. Although legally allowed, misuse of stop payment can lead to legal consequences if the cheque was issued for discharge of a lawful liability. Banks must strictly comply with such instructions.

  • Account Closed

When a cheque is presented after the drawer’s bank account has been closed, it is dishonoured. Once an account is closed, the bank has no authority to make payments from it. Dishonour due to account closure indicates negligence or dishonest intention on the part of the drawer. This reason is treated seriously in banking practice and may attract legal action under the Negotiable Instruments Act. Banks ensure that customers settle all outstanding cheques before closing accounts.

  • Difference Between Amount in Words and Figures

If the amount written in words differs from the amount written in figures, the cheque may be dishonoured due to ambiguity. Banks cannot take the risk of paying an incorrect amount. Accuracy in mentioning the cheque amount is essential for smooth banking operations. Dishonour for this reason emphasizes the importance of careful completion of cheques. It also safeguards both the bank and the customer from disputes arising due to unclear payment instructions.

  • Irregular or Incomplete Cheque

A cheque may be dishonoured if it is incomplete or irregular in form. Missing date, absence of signature, unclear payee name, or damaged cheques are considered irregular instruments. Banks require cheques to fulfill all legal and procedural requirements before making payment. Dishonour in such cases ensures compliance with banking rules and legal standards. This reason highlights the importance of issuing cheques correctly to avoid inconvenience and rejection during clearing.

Procedure to File a Complaint

  • Complaint must be filed within 30 days after the expiry of the 15-day notice period

  • Complaint should be filed in the court having jurisdiction

  • Complaint must be made by the payee or holder in due course

Defences Available to Drawer

The drawer may defend himself by proving that:

  • Cheque was not issued for a legally enforceable debt

  • Notice was not properly served

  • Cheque was lost or misused

  • Payment was already made

Importance of Dishonour Provisions

The provisions relating to dishonour of cheques:

  • Promote financial discipline

  • Enhance credibility of cheque transactions

  • Protect the interests of payees and holders

  • Strengthen confidence in banking operations

Grounds for Dishonor of Cheque

Dishonour of a negotiable instrument occurs when it is not accepted or not paid as required by law. Under the Negotiable Instruments Act, 1881, dishonour may take place on two main grounds: Non-Acceptance and Non-Payment.

(A) Dishonour by Non-Acceptance

Dishonour by non-acceptance applies mainly to bills of exchange. A bill is said to be dishonoured by non-acceptance when the drawee refuses or fails to accept the bill when it is duly presented for acceptance.

  • Refusal to Accept the Bill

A bill is dishonoured by non-acceptance when the drawee expressly refuses to accept it. Such refusal may be oral or written. Once refusal is made, the holder need not wait until maturity and can immediately treat the bill as dishonoured and take legal action.

  • Failure to Accept within Prescribed Time

If the drawee does not accept the bill within 48 hours after it is presented for acceptance, it is deemed to be dishonoured by non-acceptance. Silence or inaction on the part of the drawee amounts to refusal and gives the holder the right to proceed against prior parties.

  • Qualified or Conditional Acceptance

When the drawee gives a qualified or conditional acceptance that varies the terms of the bill, and the holder does not consent to it, the bill is treated as dishonoured by non-acceptance. Such acceptance alters the original obligation and is not binding unless agreed upon by the holder.

  • Drawee Incompetent to Contract

If the drawee is legally incompetent to contract, such as being a minor or of unsound mind, the bill is dishonoured by non-acceptance. Acceptance by an incompetent person has no legal effect, and the holder may treat the bill as dishonoured.

  • Drawee Cannot Be Found

If the drawee cannot be located even after reasonable search when the bill is duly presented for acceptance, the bill is considered dishonoured by non-acceptance. The holder is not required to make repeated attempts and can proceed against other parties.

(B) Dishonour by Non-Payment

Dishonour by non-payment applies to promissory notes, bills of exchange, and cheques. It occurs when the instrument is duly presented for payment and payment is refused or cannot be obtained.

  • Refusal to Pay on Maturity

An instrument is dishonoured by non-payment when the maker, acceptor, or drawee refuses to make payment on the due date. Refusal may be express or implied. Once refusal occurs, the holder has the right to sue and take legal action against liable parties.

  • Insufficient Funds

If payment is refused due to insufficient funds in the account of the drawer or acceptor, the instrument is dishonoured by non-payment. In the case of cheques, this ground may attract criminal liability under Section 138 of the Negotiable Instruments Act, 1881.

  • Death or Insolvency of the Party Liable

If the party primarily liable to pay has died or become insolvent, and payment cannot be obtained from his legal representative or official receiver, the instrument is dishonoured by non-payment. This gives the holder the right to proceed against endorsers and other prior parties.

  • Stop Payment Instructions

When the drawer issues stop payment instructions to the bank, the cheque is dishonoured by non-payment. Even if sufficient funds exist, refusal by the bank results in dishonour. Such dishonour may still attract legal liability if the cheque was issued for a lawful debt.

  • Expiry of Validity or Presentment Defects

If an instrument is presented after its validity period or not presented in the manner prescribed by law, payment may be refused. This leads to dishonour by non-payment, though it is technical in nature and may not always result in legal liability.

Management Notes

Statutory Protection to the Paying Banker

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Statutory Protection ensures that a paying banker is safeguarded against liabilities when acting in good faith and in accordance with the law. The Negotiable Instruments Act, 1881 provides various provisions under which a paying banker can seek protection while making payments. Below are key aspects of statutory protection to a paying banker:

Protection Under Section 85 – Payment of Order Cheque:

Under Section 85(1) of the Negotiable Instruments Act, 1881, a banker is protected when paying an order cheque to the rightful person. If a cheque is properly endorsed and paid in due course, the banker is not liable even if a fraud has occurred.

For instance, if a cheque is stolen and the bank pays it to an innocent holder in due course, the bank is not liable for the loss, provided all banking protocols were followed. This protection ensures smooth transactions and prevents undue risks to banks.

Protection Under Section 85(2) – Payment of Bearer Cheque:

A paying banker is protected when making payments on bearer cheques under Section 85(2). If a cheque is marked “bearer,” the bank can legally pay any person who presents it, even if it was lost or stolen. The banker is not required to verify the identity of the holder.

For example, if Mr. X writes a bearer cheque for ₹5,000, anyone who presents it at the bank can receive the amount. If later found to be fraudulent, the banker is still protected if the cheque was paid in good faith and in due course.

Protection Under Section 128 – Payment of Crossed Cheques:

According to Section 128, a paying banker is protected if a crossed cheque is paid to a bank and ultimately credited to the correct account. Crossed cheques have two parallel lines, ensuring they are not encashed directly but deposited into a bank account.

For example, if a cheque is marked “A/C Payee Only”, the bank must ensure that it is credited to the correct payee’s account. If the bank follows this rule, it is protected from liability in case of fraud or theft.

Protection Under Section 10 – Payment in Due Course:

A banker is protected if they make payment in due course, as per Section 10 of the Act. This means the bank has checked all essential details such as:

  • Proper endorsement

  • No alterations

  • Payee’s identity

  • Fund sufficiency

If a banker pays a cheque in due course and later finds out it was forged or fraudulent, the bank is not held liable.

Protection Against Forged Endorsements:

The banker is protected if a cheque is paid to a person whose endorsement appears genuine. However, if the drawer’s signature is forged, the banker is liable. The distinction ensures that banks remain vigilant while verifying customer signatures.

For instance, if Mr. A issues a cheque to Mr. B, and Mr. B’s signature is forged during an endorsement, but the bank pays in good faith, the banker is not held responsible. However, if Mr. A’s original signature was forged, the bank is liable.

Protection Against Stop-Payment Orders:

If a customer has issued a cheque and then gives a stop-payment order after the bank has processed the payment, the banker is not responsible for refunding the amount. This protects banks from unnecessary legal battles.

For example, if a business issues a cheque to a supplier but later changes its mind and requests a stop-payment, the bank is not liable if the cheque has already been cleared.

Protection from Customer Claims:

If a banker has followed legal and procedural requirements while paying a cheque, the customer cannot sue for wrongful payment. The law ensures that banks operate without fear of undue litigation if they act in good faith and within banking norms.

For example, if a cheque is paid based on a genuine signature and later the customer disputes it, the banker is protected under statutory provisions.

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