Chapter Five

Bank Services
5.1. Introduction
The most important service of a bank is to accept deposits from the public and advance it to
borrower. A bank provides facilities to open various types of accounts keeping in mind the needs of its
customers.
This chapter discusses about the meaning of a loan, its classification, loan policy, loan administration, etc.
5.2. Opening an Account
As already discussed in the previous chapters, the opening of an account involves the honoring of
cheques on the part of the bank so long as customer’s account has credit balance.
When the bank does not adequately know the customer, it may result in wrong payment or
encashment of forged cheques. Hence, it is essential that the bank should make a through enquiry regarding
the customer before opening an account with him. For this purpose, the bank follows different procedures to
open accounts. Those procedures have been discussed in the previous chapter.
5.3. The Paying Banker
When a bank accepts the deposits from a customer, it becomes the debtor of the customer and it will
be bound to return the equivalent amount to the customer or his order on demand. In other words, it is the
obligation of the bank to honor the cheques issued by the customer if the following conditions are fulfilled:
(a) There is sufficient balance in the account of the customer;
(b) The cheque is properly drawn and presented; and
(c) There is no legal restriction on payment.

The banker who is liable to pay the value of a cheque of a customer as per the contract, when the
amount is due from him to the customer is called “Paying Banker” or “Drawee Bank.”

Paying banker has a legal obligations to honor the demand of the drawer or customer. If he fails to
pay the money held, he is liable for damages. Thus paying banker has certain obligations to discharge.
Precautions for Payment of Cheques
Honoring of cheques drawn by his customer is a very important obligation of a banker. He should
not dishonor his customer’s cheques without adequate ground. The customer can claim damages for the
injury caused to his credit owing to wrongful dishonor of cheques.
Further, if he honors a cheque which is not properly drawn or contrary of the instructions of his
customer or against the intention of his customer or when the customer has no adequate balance, he gets
into trouble. The paying banker in such a condition is said to be in “between the devil and the deep sea.”

 The banker has to take the following precautions while honoring the cheques of his customers:
1. Proper Form: A banker should see whether the cheque is in the proper form.
2. Open or Crossed Cheque: The most important precaution that a banker should take is about crossed
cheques.
A banker has to verify whether the cheque is open or crossed. He should not pay cash across the
counter in respect of crossed cheques. If the cheque is a crossed one, he should see whether it is a general
crossing or special crossing.

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  If it is a general crossing, the holder must be asked to present the cheque through some banker. It
should be paid to a customer.
 If the cheque bears a special crossing, the banker should pay only the customer whose name is
mentioned in the crossing.
If it is open cheque, a banker can pay cash to the payee or the holder across the counter. If the banker
pays against the instructions as indicated above, he is liable to pay the amount to the true owner for any
loss sustained. Further, a banker loses statutory protection in case of forged endorsement.
3. Place of Presentment of Cheque: A banker can honor the cheques provided is presented with that
branch of the bank where the drawer has an account.
If the cheque is presented at another branch of the same bank, it should not be honored unless special
arrangements are made by the customer in advance. The reasons are:
(a) A banker undertakes to pay cheques only at the branch where the account is kept.
(b) The specimen signature of the customer will be with the office of the bank at which he has an account.
(c) It is not possible for other branches to know that the customer has adequate balance to meet the cheque.
4. Date of the Cheque: The paying banker has to see the date of the cheque. It must be properly dated. It
should not be either a post-dated cheque or a stale-cheque.
If a cheque carries a future date, it becomes a post-dated cheque. If the cheque is presented on the
date mentioned in the cheque, the banker need not have any objection to honour it. If the banker honours a
cheque before the date mentioned in the cheque, he loses statutory protection. If the drawer dies or becomes
insolvent or canceled payment before the date of the cheque, he will lose the amount. The undated cheques
are usually not honored.
A stale cheque is one which has been in circulation for an unreasonably long period. The custom of
bankers in this respect varies. Generally, a cheque is considered stale when it has been in circulation for
more than six months. Banker does not honor such cheques. However, banker may get confirmation from
the drawer and honor cheques which are in circulation for a long time. So, verification of date is very
important.
5. Mutilated Cheque: The banker should be careful when mutilated cheques are presented for payment. A
cheque is said to be mutilated when it has been cut or torn, or when a part of it is missing.
Mutilation may be either accidental or intentional.
If it is accidental, the banker should get the drawer’s confirmation before honouring it. If it is
intentional, he should refuse payment. The cheque is to be returned with a remark ‘Mutilated cheque’ or
‘Mutilation Requires Confirmation’.
6. Words and Figures: The amount of the cheque should be expressed in words, or and figures, which
should agree with each other. When the amount in words and figures differ, the
banker should refuse payment.
However, some regulation provides that, where there is difference between the amount in words and
figures, the amount in words is the amount payable . If the banker returns the cheque, he should make
a remark ‘amount in words and figures differ’.
7. Alterations and Over writings: The banker should see whether there is any alteration or over-writing on
the cheque. If there is any alteration, it should be confirmed by the drawer by putting his full
signature. The banker should not pay a cheque containing material alteration without confirmation

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 by the drawer. The banker is expected to exercise reasonable care for the detection of such
alterations. Otherwise, he has to take risk. Material alterations make a cheque void.
8. Proper Endorsements: Cheques must be properly endorsed. In the case of bearer cheque, endorsement is
not necessary. In the case of an order cheque, endorsement is necessary. A bearer cheque always
remains a bearer cheque.
The paying banker should examine all the endorsements on the cheque before making payment.
They must be regular. But it is not the duty of the paying banker to verify the genuineness of the
endorsements, unless the cheque bears ‘Not-Negotiable’ crossing. He is not expected to know the signatures
of all payees. So he gets statutory protection in case of forged endorsements.
9. Sufficiency of Funds: The banker should see whether the credit balance in the customer’s account is a
sufficient to pay the cheque or not. If there is an overdraft agreement, he should see that the limit is
not exceeded. The banker should not make part-payment of the cheque. He should pay either full
amount or refuse payment. In case of insufficiency of funds, the banker should return the cheque
with the remark ‘No Funds’ or ‘Not Sufficient Funds’.
10. Verification of Drawer’s Signature: The banker takes specimen signatures of his customers’ at the
time of opening the account. If there is any difference or doubt, he should not honour the cheque. He
should get the confirmation of the drawer. If there is forgery and there is negligence on the part of
the banker to detect the same, there is no protection to the banker.
 Statutory Protection
The legal duty of a paying banker is full of risk because payment of cheques may not be made to the
right person. In case a payment is made to a wrong person by bank, the loss will be borne by the banker. In
banking practice, the banker honors the cheques of his customers and cannot make enquiries and
investigations about the title and status of the person who presents the cheque for payment at the counter of
the bank.
 Dishonor of Cheques
In addition to the aforesaid precaution cases ,a paying banker must refuse payment on cheques, issued by his
customers, in the following circumstances:
1. Notice of the Customer’s Death: The banker should not make payments on cheques presented after the
death of the customer. He should return the cheque with the remark ‘Drawer Deceased’. However, if
the payment is made without knowing the fact of the customer’s death, the banker cannot be held
liable.
2. Notice of Customer’s Insanity: The banker should stop the payment on cheques drawn and received
after the receipt of notice of the customer’s insanity. He can believe that the customer is insane only
when he/she is sent to the lunatic asylum.
3. Notice of the Customer’s Insolvency: A banker should refuse payment on the cheques soon after the
customer is adjudicated as insolvent.
4. Receipt of the Garnishee Order: Where Garnishee order is received attaching the whole/ specified
amount, the banker should stop payment on cheques received after the receipt of such an
order wholly/partially.
5. Notice of Assignment: The banker should stop the payment, on receipt of the notice of assignment
signed by the customer of the credit balance in his account.
6. Trust Accounts: If the banker feels suspicious that the trustee wants to use the amount of the cheque for
his personal use, he must stop payment.
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7. Suspicion about the Title over the Cheque: When the banker believes that the person presenting the
cheque is not entitled to receive the payment, he should refuse to make payment.
 When a Banker can Dishonour Cheques
A banker may dishonour a cheque without incurring any liability in the following cases:
1. Post-dated Cheques: Refusal to pay before the date mentioned on the cheque does not amount to
dishonour. So, post-dated cheques can be dishonoured.
2. Insufficiency of Funds: The banker can refuse to pay the amount if the funds are not sufficient.
However, the banker may honour the cheque if he feels that the customer is a trustworthy and long-
standing customer.
3. Presentation of Cheque: The banker may refuse the cheque of his customer if it is not duly presented.
4. Joint Accounts: In the case of joint account, the banker can refuse to make payment on the cheque if it is
not signed by all the joint account holders.
5. Material Alterations: When there is material alteration in the cheque, the banker may refuse payment.
6. Stale Cheques: When the cheque is presented after the period of six months from the date it bears, the
banker may refuse to make payment.
7. Drawer’s Signature: If the signature of the drawer on the cheque does not tally with the specimen
signature, the banker may refuse to make payment.
8. Difference between Words and Figures: If there is difference between the amount written in words and
figures, the banker may refuse to make payment.
9. Endorsement: If the endorsement is irregular, the banker may refuse payment on the cheque.
10. Proper Form of the Cheque: If the cheque is not in the proper form and with conditions, the banker
should refuse the payment.
11. Drawn on Another Branch: If the cheque is presented at another branch of the same bank, it should
not be honored unless special arrangements are made by the customer in advance.
 Bank’s Remarks on Dishonored Cheques

When a cheque is returned unpaid, the banker should attach a slip containing brief remarks, to
convey the reason for dishonoring the cheque. The following remarks are generally made:
(a) R.D. (Refer to Drawer): This remark is used only when there is reasonable ground to suspect the
genuineness of the cheque.
(b) N.S. (Not sufficient), N.E. (No. Effects): These are used where the drawer’s balance is inadequate to
meet the cheque.
(c) E.I. (Endorsement Irregular)
(d) E.N.C. (Effect is not cleared): This is used when cheques deposited are not yet collected and not
available for withdrawal.
5.4. Collecting Banker
Collecting banker means the banker who collects the cheques and bills on behalf of the customers.
While collecting the cheques of a customer, the banker may act in the capacity of either
(a) As a holder for value, or
(b) As an agent of the customer.
The legal position of the collecting banker under these two circumstances is discussed below.
 Collecting Banker as Holder for Value

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 A collecting banker is holder for value if he gives the value of the cheque in any form to its customer
before collecting the proceeds of the cheque deposited by the latter. He does not remain an agent of the
customer, but becomes the owner of the cheque in his own right since he has paid value for it, and has
acquired the ownership right in good faith. In such a situation, the banker is called holder for value and he is
also the holder in due course.
According to Paget, a banker becomes a holder for value in the following ways by:
(a) lending further on the strength of the cheque;
(b) paying the amount of the cheque or part of it in cash or in account before it is cleared;
(c) agreeing that the customer may draw before the cheque is cleared;
(d) accepting the cheque in confirmed reduction of an existing overdraft;
(e) giving cash over the counter for the cheque at the time it is deposited in for collection.

In the above circumstances, the banker becomes the holder for value. Further, if he proves that he
gave value for a cheque in good faith, he will be able to resist any claim by the true owner provided that (a)
the cheque was not tainted with forgery, (b) he had no notice of any previous dishonor or of any defect in
the title of his customer, (c) the cheque was not crossed ‘not negotiable’ (d) the cheque was not overdue for
the purpose of negotiation, and (c) the cheque was regular on the face of it in all respects.
If the cheque is dishonored, the collecting banker can use all the previous parties after giving them
the notice of dishonor. The banker undertakes a risk also when he acts as a holder for value. He will be in a
difficulty if last, but one endorsement proves to be a forged one. The banker will be liable to the true owner
of the cheque. However, he can recover the amount from his customer.
 Collecting Banker as an Agent of the Customer
When a collecting banker acts as an agent of the customer, he credits the latter’s account with the
amount of the cheque after the proceeds of the cheque are actually collected from the drawee banker. The
customer can draw the amount after his account is credited with the proceeds. In such a case, banker acts as
an agent of his customer and does not get better title to the cheque than that of the customer. If the title of
the customer is defective, the banker will run the risk of being liable to the true owner if it collects the
cheque.
If the cheque collected by the banker does not belong to his customer, the banker will be liable for
‘conversion of money’ or in other words, for illegally interfering with the rights of the true owner of the
cheque.
As an agent of the customer, the collecting banker is a mere “conduit pipe to receive payment of the
cheque from the bank on which it is drawn and holds the proceeds at the disposal of the customer.”
Conversion
According to Dictionary of Banking, “Conversion is a legal term signifying wrongful interference
with another person’s property inconsistent with another’s right of possession.”Conversion applies only to
tangible property and not to debts. Negotiable Instruments are included in the term ‘property’. The
collecting banker may be charged for conversion if he collects a cheque for a customer having defective title
to it.
The collecting banker while collecting the payment of a cheque to which his customer has defective
title, deprives the true owner of the cheque to receive payment. So he incurs a liability to the true owner of
the cheque. The principle which is applied here is that a rightful owner of the cheque can recover the same

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from anyone who takes it without his authority and in whose hands it can be traced. But the banker has been
granted statutory protection in certain circumstances which are discussed later.
In the following cases, the banker is liable for conversion to the true owner of the instrument:
(a) When he collects a cheque, a bill of exchange, or a promissory note bearing a forged endorsement or in
respect of which the customer has no title at all;
(b) When he borrows for his customer the proceeds of a cheque on which the customer has no title or only
defective title;
(c) When he takes as holder for value, a cheque marked ‘not negotiable; and
(d) When he delivers to the wrong person the goods entrusted with him for safe custody.

In the following cases, the banker is not liable for conversion to the true owner of a cheque:
(a) Where there is no forgery and the instrument comes into the hands of the holder in due course; and
(b) Where there is forgery and the instrument is a cheque, payment whereon has been made in due course by
the banker.
Statutory Protection to Collecting Banker
A collecting banker can claim protection against conversion if the following conditions are fulfilled.
1. Good Faith and Without Negligence: Statutory protection is available to a collecting banker when he
receives payment in good faith and without negligence.
The burden of proving that he collected in good faith and without negligence is on the banker. The
banker should have exercised reasonable care and diligence. What constitutes negligence depends upon
facts of each case.
The following are a few examples which constitute negligence:
(a) Failure to obtain reference for a new customer at the time of opening the account.
(b) Collection of cheques payable to ‘trust accounts’ for crediting to personal accounts of a trustee.
(c) Collecting for the private accounts of partners, cheques payable to the partnership firms.
(d) Omission to verify the correctness of endorsements on cheques payable to order.
(e) Failure to pay attention to the crossing particularly the “not negotiable crossing.”
2. Collection for a Customer: Statutory protection is available to a collecting banker if he collects on
behalf of his customer only. If he collects for a stranger or noncustomer, he does not get such
protection. A bank cannot get protection when he collects a cheque as holder for value.
3. Acts as an Agent: A collecting banker must act as an agent of the customer in order to get protection. He
must receive the payment as an agent of the customer and not as a holder under independent title.
4. Crossed Cheques: Statutory protection is available only in case of crossed cheques.It is not available in
case uncrossed or open cheques because there is no need to collect them through a banker. Cheques,
therefore, must be crossed prior to their presentment to the collecting banker for clearance. In other
words, the crossing must have been made before it reached the hands of the banker for collection. If
the cheque is crossed after it is received by the banker, protection is not available. Even drafts are
covered by this protection.
 Duties and Responsibilities of a Collecting Banker
The duties and responsibilities of a collecting banker are discussed below:
1. Due care and diligence in the collection of 3. Agent for collection.
cheque. 4. Remittance of proceeds to the customer.
2. Serving notice of dishonor. 5. Collection of bill of exchange.

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1. Due Care and Diligence in the Collection of Cheques: The collecting banker is bound to show due care
and diligence in the collection of cheques presented to him.
In case a cheque is entrusted with the banker for collection, he is expected to show it to the drawee
banker within a reasonable time.
In case a collecting banker does not present the cheque for collection through proper channel within
a reasonable time, the customer may suffer loss. In case the collecting banker and the paying banker are in
the same bank or where the collecting branch is also the drawee branch, in such a case the collecting banker
should present the cheque by the next day. In case the cheque is drawn on a bank in another place, it should
be presented on the day after receipt.
2. Serving Notice of Dishonor: When the cheque is dishonored, the collecting banker is bound to give
notice of the same to his customer within a reasonable time.
If the collecting banker fails to give a notice, the banker will be liable to the customer for any loss
that the customer may have suffered on account of such failure.
Whereas a cheque is returned by the drawee banker for confirmation of endorsement, it is not called
dishonor. But in such a case, notice must be given to the customer. In the absence of such a notice, if the
cheque is returned for the second time and the customer suffers a loss, the collecting banker will be liable
for the loss.
3. Agent for Collection: In case a cheque is drawn on a place where the banker is not a member of the
‘clearing-house’, he may employ another banker who is a member of the clearing-house for
the purpose of collecting the cheque. In such a case the banker becomes a substituted agent.
4. Remittance of Proceeds to the Customer: In case a collecting banker has realized the cheque, he should
pay the proceeds to the customer as per his (customer’s) direction.
Generally, the amount is credited to the account of the customer on the customer’s request in
writing; the proceeds may be remitted to him by a demand draft. In such circumstances, if the customer
gives instructions to his banker, the draft may be forwarded. By doing so, the relationship between principal
and agent comes to an end and the new relationship between debtor and creditor will begin.
5. Collection of Bills of Exchange: There is no legal obligation for a banker to collect the bills of exchange
for its customer. But, generally, bank gives such facility to its customers.
The collecting banker must examine very carefully the title of his customer towards the bill. In case
a new customer comes, the banker should extend this facility to him with a trusted reference.
Marking of Cheque
The marking of cheque means “a cheque which is marked or certified by the drawee banker, to the
effect, that it is good for payment.” The drawee bank certifies that the drawer of the cheque has sufficient
balance in his account and the cheque will not be dishonored due to lack of funds. Such a certificate is
known as “Marking of Cheques.”
Generally, the marking of a cheque is done by drawee in writing the words “good for payment”
across one corner of the cheque, with the signature of the bank’s authorized official and the bank’s stamp.
The marked cheques are very useful for businessmen as they can purchase the goods required by them, and
the sellers will accept the marked cheques like currency-notes. It is to be noted here that marking post-dated
cheques is not valid.
 Who Can Get the Cheque Marked?
The marking of cheques may be done at the request of:
(a) the drawer (b) the holder, and (c) another banker.

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These have been discussed below.
(a) Marking at the Request of the Drawer: Whereas a cheque is marked by the drawee bank at the request
of the drawer, the latter cannot stop payment. In such case, the banker is bound to honour the cheque
so marked by it. In case the drawer dies or becomes insane, the banker will have to make the
payment because of the cheque having been marked at the request of the drawer.
(b) Marking at the Request of the Holder: The marking of a cheque at the request of the holder or payee
does not virtually place any liability on the paying banker. If a customer has sufficient funds in his
account and he presents a cheque for payment, the banker will honor the cheque immediately.
(c) Marking at the Request of Another Banker: When a banker marks a cheque at the request of another
banker for clearance purposes, the paying banker is undertaking an obligation to honour it. In actual
practice, marking a cheque for clearance purposes entitles the paying banker to earmark the
necessary funds to meet the cheque.
For the significance of marking of cheque, it is necessary that the sufficient balance of money must be on
credit with the drawer on that particular date.
5.5. Loan and Advances
5.5.1. Meaning of Loans and Advance
Loans and advance are money granted by creditor to a debtor to be paid in a future fixed period with
an interest. To the debtor, loan means getting the purchasing power (i.e., money) now by a promise to pay at
some time in future.
5.5.2. Classification of Loans and Advances
One of the main questions of banks is advancing loans to customers in different ways for different
purposes and for different time span. Hence bank loans and advances can be classified into different
categories using different criterion such as nature ,purpose, time, security and method of repayment.
repayment.
5.5.2.1. Based on the Nature of the Loan
A bank may make advances to traders and industrialists and others in many ways. But the main
forms in which money is advanced by the bank are: loans, cash credits, overdrafts, purchase and discounting
bills and call/notice loans.
A) Call/Notice Loans: are types of loans that are granted for a customer for a period of from an overnight
to a maximum of 14 days. It is used for temporary purposes and are granted without securities.
B) Cash Credit: it is an arrangement under which a borrower is allowed to borrow up to a certain limit
with the security of tangible assets or guarantees. Thus, cash credit may be regrouped as a secured
cash credit and a clean cash credit.
In case of a cash credit, the customer need not withdraw the entire amount as in case of a loan. He can
withdraw from his cash credit account any amount within the limit specified as and when required and can
deposit any amount of money, which he finds surplus with him. Thus, unlike loan account, cash credit
account is a running account from and to which withdrawals and deposits can be made frequently.
The customer has to pay the interest only on the amount actually utilized by him and not on the limit
granted. If the cash credit is a secured one, securities furnished by the customer can be increased or
decreased according to the amount withdrawn and the customer is allowed to replace one kind of security
with another.
The limit of cash credit is fixed by the bank very carefully after considering a number of factors such
as production, sales, inventory levels, credit worthiness of the borrower etc. A cash credit is repayable on

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demand though in practice the limit is available for a stipulated period. The securities offered by the
borrower can be adjusted according to the amount withdrawn.
When a bank grants cash credit to a customer,
customer, it fixes a ceiling or limit beyond which the customer
cannot draw but within which he can draw any amount he likes. likes. The customer need not withdraw the
amount in one lump sum; he can withdraw according to his requirements.
The drawback of cash credit system is the existence of large unutilized credit limits.
limits. The unutilized
portion of the credit limit is to be taken as the difference between the borrower's requirement and the
average use of credit during each quarter. This portion of the cash credit remains unutilized and idle which
the borrower normally do not pay interest. It will not be income-earning asset to the banker. Therefore, the
banker charges a penalty rate usually 1% to compensate the loss encountered by the banker while
maintaining idle cash for the benefit of the customer.
C) Overdrafts: a person is said to be availing overdraft from a bank, when his account with the bank
shows a debit balance. Under this arrangement, the bank allows its customer to overdraw his current
account so that it shows a debit balance. Any business person can enter into this arrangement to tide
over a temporary shortage of funds. The bank may take some tangible security of the borrower. The
customer can draw his fund as and when he requires and repay it when it is convenient for him.

The operation of overdraft is same as that of cash credit with the main difference that cash credit is a
little long-period accommodation. The customer is charged interest on the amount actually overdrawn by
him and not on the limit sanctioned. He will be charged no interest if he does not overdraw at all during a
particular period.
In practice, the arrangement for overdraft and cash credit is identical except that in the case of an
overdraft the arrangement is in relation to a person's current account. Thus, the extension of overdraft
facility presupposes the existence of a current account in the name of the borrower.
Overdrafts are the withdrawals made according to the convenience of the customer. A sudden spurt
in withdrawals will reverse the plans of the banker. However, the banker while permitting the operation of
the overdraft account fix the limit of overdraft. Hence, the bankers plan takes into account these
arrangements. Overdrafts facilities are granted for six months time with subject to renewal up on the
agreement of both parties.
D) Purchase and Discounting of Bills of Exchange: the bank provides the customers with the facility of
purchasing and discounting their bills receivable.
E) Loans: when a bank makes an advance in lump sum the whole of which is withdrawn in cash
immediately by the borrower who undertakes to repay it in installments, it is called a loan . Here advance
is made on a separate loan account to which the whole amount of loan is immediately credited.
The borrower is required to pay the interest on the whole amount from the date of sanction withheld
draws the full amount from the loan account or not. If he does not withdraw the entire amount, the real rate
of interest will be higher than the rate of interest on cash credits and overdrafts. In some cases, the bank may
also agree for the repayment of loan in installments.
A loan is different from a cash credit. Cash credit is of a continuing nature, i.e., money can be
withdrawn or paid into the cash credit account and interest will be charged only on the actual credit. But in

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case of a loan, the interest is charged on the entire amount and a loan once repaid in full or in part cannot be
drawn again.
A borrower has to apply for a fresh loan if he needs funds. The second transaction will be totally
distinct from the first one. Commercial Banks generally advance loans for short-terms and medium terms.
Since the banks charge interest on the entire amount of loans, this way of raising funds is costy to the
customer as compared to cash credits and overdrafts.

The banker prefer loans to cash credit because of two reasons:

a) The bank can charge interest on the entire amount of the loan Sanctioned or disbursed.
b) Loan account involves a smaller operating cost than overdraft or cash credit because in the latter case
there is a continuity and magnitude of operation.
5.5.2.2. Based on the Purpose of the Loan
On the bases of the purpose, the loan is granted for, loans can be sorted out in to the following groups.
A) Commercial Loans: they are types of loans granted for commercial purposes i.e., to facilitate
transactions being made between different firms. They have a short-term life.
B) Industrial Loans: are loans granted to industrialists for the purpose of constructing or buying
industrial buildings and to buy other fixed assets. Therefore, they have a long-term life.
C) Agricultural Loans: they are types of loans to be granted to the agriculturalists. They may be given for
the purpose of buying land, cultivating and developing the land, buying tractors, fertilizer,
insecticide, selected seeds, etc. They have both short life and long life.
D) Educational Loans: they are granted to finance education expenses of a customer.
E) Medical Loans: they are granted to a customer in order to finance his medication expenses.
5.5.2.3. Based on the Period of the Loan Granted
Loans may be granted for different span of time. Some may given for short time span and others for
long time span and others for intermediate time span. Accordingly loans are divided into three groups.
a) Short-term loans: they are loans usually granted for a period of time up to and less than one year.
b) Intermediate loans: they are loans usually granted for a period of time from one up to five years.
years.
c) Long-term loans: they are granted for a period of time above five years.
years.

Note:
Note: This way of classification seems a bit practice, otherwise there is no general rule that dictates loans to
be classified on the bases of this time horizon. Different banks can set different time horizon so as to
classify as short, intermediate, and long-term loans.
5.5.2.4. Based on the Nature of Security
Loans may be classified based on their level of guarantee as secured and unsecured loans.
A) Unsecured or Clean Loans/Advances: the loan allowed by a bank to a business person without any
security of tangible assets is known as unsecured loans/Advances. It is allowed to the customer without his
personal security or promissory note.
Banks may allow unsecured advances in the following ways:
i. cash credit against hypothecation of movable property.
ii. purchasing and discounting of bills of exchange
iii. purchasing and discounting of documentary bills covering exports.

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 iv. advances against promissory notes guaranteed by one or more persons of good credit
worthiness.
v. advances against government supply bills.
Unsecured loans are risky as in such cases, bank relies entirely on the integrity, reputation and
strength of character of the borrower. Banks generally advance clean advances to big business persons who
command faultless reputation in the business world. Clean limit is generally granted to supplement the limit
granted on a secured basis.
B) Secured Advances/Loans: by secured advances we mean those advances which are granted against
some tangible securities apart from the promissory note of the borrower. Secured loan or advance
means a loan made on the security of assets, the market value of which is not at any time less than
the amount of such loan or advance.
The securities against advances are also known as "collaterals". Collateral means additional and
securities offered by the borrower and called collaterals because they are offered in addition to the personal
security of the borrower. They can be disposed of only in the event of the failure of the borrower to repay
the loans.
The value of the securities is to be taken at market price and not at the cost price or book value for
the purpose of making an advance. If a customer applies for a loan of Br 400,000.00 and offers shares of the
nominal value of Br 300,000.00 as security. The bank should immediately try to know the market value of
the shares. Let us suppose the real value of the share is Br 200,000.00. In such a case, it is advisable for the
bank to advance loan of Br 200,000.00. Bank cannot be called partly secured in this case because there is no
such term in the banking practice.
This implies that the market value of the securities should be equal to or more than the amount of
advance throughout the currency of the loan. That is why, banks generally restrict the loan up to 60 to 70
percent of the market value of the security offered.
Collateral securities, which are offered in addition to the personal security of the borrower against an
advance made to him may take any form of the following.
1. Any security in physical form lodged by the borrower or a third party as also the guarantee given by a
third party.
2. Two or more securities which cover the same debt, e.g., hypothecation of goods and mortgage of
property.
3. Third party guarantee given in addition to the borrower's guarantee. This would enable the banker to
recover the maximum amount possible form the estate of the borrower by claiming the full amount of the
advance (or by reducing the amount of any direct security deposited) and thereafter utilizing the third
party security for making good the deficit in the amount, if any.
5.5.3. Principles of Guidelines for Secured Advances
The bank earns interest over different advances, which is an important source of income for it. But at
the same time, the bank has so many risks associated with the advances. In order to avoid these risks a bank
has to follow some general principles while lending money. The most important principles of sound lending
are liquidity, profitability and safety.
 Liquidity is important to ensure that the demands of the depositors are met easily.
 Profitability is essential to meet the expenses of the bank and to earn sufficient profits.

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  Safety of the funds is very essential for the survival of the bank. In order to follow this principle,
banks insist on securities against the various types of advances. But, however, a bank is not merely
guided by the security.
To cover up the advance, it is guided by many other considerations. These considerations can be discussed
as follows:
A) Credit-worthiness of the borrower: Credit-worthiness of the borrower is based on his reliability,
responsibility and resources. The bank should give loan to the person who is reliable and a man of integrity
and has the intention to repay the loan.
If some loss takes place, he should have the capacity to bear it. Thus, the first principle requires that a
bank must satisfy itself that the proposed borrower is honor, reliable, responsible and financially sound.
B) Financial position of the borrower: It should ask for the profit and loss account and balance sheet of
the last few years. This will help the bank to know the nature of the business and liquidity position of the
assets of the borrower.
C) Purpose of the loan: The loan must be granted to increase the income earning capacity of the borrower
because, otherwise, he will not be able to pay back the loan.
D) Amount and Period of Loan: a bank cannot grant big loans to a few individuals or concerns. Similarly,
a bank cannot grant loan for unduly long periods because a major portion of its deposits represents
demand deposits which are repayable on demand, so the bank must consider the period of loan while
examining the proposal from the borrower.
E) Security Offered: the bank should also consider the nature of security offered for the advance. A bank
should accept that type and real owner security, which is easily marketable and stable in value.
F) Adequate Margin: a bank should not lend up to the full value of the security provided because its value
may go down with the passage of time. It must keep a sufficient margin so that it does not suffer loss
because of loss in its value due to depreciation or fall in its price when the borrower makes difficult in
making the payment.
G) Diversification: the advances of the banks must be spread over different regions, industries and sectors.
5.5.4. Consideration for sound lending
The banker, before advancing loans to customers should take certain considerations. These considerations
are related to the bank itself, the borrower and the project.
A) Consideration About the Bank Itself
The banker should investigate his home regarding its liquidity, solvency and profitability, before advancing
loans to customers.
B) Consideration About the Customer
Banks do not advance loans to anyone who demands credit. Not all applicants are genuine. There are
people who apply for loan from the bank either without having a well studied project, or without having the
required skill to manage the business or with some purpose other than stated in the application. Therefore, a
banker before advancing loans to applicants, be has to evaluate and select the right applicant that can
properly utilize the loan amount and who can make more value /surplus/ on the project. So as to do that the
bank can appraise the following five C's about a customer.
i) Character: here we can weigh the behavior of the applicant.
ii) Capacity:
Capacity: the ability of the borrower to manage his business is a vital consideration made in advancing
a loan. we can see his educational level & type and his experience as an entrepreneur or as an employee.

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iii) Capital:
Capital: here we measure the financial soundness of the customer. If a customer covers majority of the
project cost, it is believed that, he will be highly committed to the success of the business/project.
iv) Credit Worthiness:
Worthiness: derived either the customers past experience with the bank or the customer's
relationship with other banks. Credit information is collected from other banks, too, for that effect.
v) Collateral:
Collateral: things do not go always right as being expected to be. The business may get bankruptcy and
the loan remain unpaid. Therefore, so as to secure the repayment of the loan the banker requires
customers to provide adequate collateral/security for the loan.

C) Consideration About the Proposal/Project

Bank loans are not free gifts that can be used by the borrower as he wish, rather it must be used for the right
purpose the loan is granted for in a regulated manner. Therefore, the banker while financing projects, it
should consider certain paints about the project/proposal such as:
i) Purpose: The purpose of a project being financed by the bank should not be contradicting to the law of
the nation. It must be legal. Besides, the project should be able to meet certain social benefits. It
must contribute the efforts of eliminating certain social problems like poverty, unemployment,
disease, famine, illiteracy, etc.
ii) Profitability/Viability: the profitability or viability of the business must be determined. It is wise to
invest in projects that attracts positive net inflow than those with negative net-inflow. Therefore, before the
bank permit loan to a customer, first the viability of the project must be studied. The projects viability can
be measured through project appraisal or feasibility study.
study.
This might be done at two stages:
1st: by the promoter for identifying the right project
2nd: by a banker or financial institution for the purpose of determining whether the project should be
financed by it or not.
5.5.5. Factors Limiting the Level of Advance
The following are factors that limit the level of loans to be advanced to borrowers.
a) The type of deposits at the bank: time and saving deposit accounts are relatively long-term than
demand deposit accounts. Hence, amount deposited in savings and time deposits can be used for long
term loans and those in demand deposit accounts are used for short-term loans.
b) Credit control by the national bank: The National Bank's financial/credit policy may be expansionary
or contracting. If the National Banks Credit Policy is expansionary, the level of credit advanced by
commercial banks will be higher than if the National Bank's credit policy is contradicting.
c) Seasonal variations: If the demand for loan is greater, the loan advanced will be higher and vice versa.
The demand for loan also will depend upon seasonal factors such as: the busy season, the harvest time,
the slack season, the festive season etc, that affects the business activities – business activities flourish
during the busy season, the harvest time and the festive season and business need more money to run its
operation at a higher level.
5.5.6. Principles for Sound Lending & Investment
While investing its funds in various assets, a bank is generally guided by the three cardinal principles:
liquidity, profitability and safety or security. They will be discussed as follows.
a) Liquidity: mean the capacity of the bank to pay cash in exchange of deposits.

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The word liquidity has two attributes.
i) ability to convert into cash quickly, and
ii) Ability to convert into cash without any loss of value.
b) Solvency: it represents the state of affairs of the bank under which a bank is able to meet its debts
obligations. A bank is said to be solvent when the value of its assets is more than (or at least equal to) the
value of its liabilities. But a bank is said to maintain liquidity when its assets can be converted into cash
quickly and without loss.
A bank may be solvent but may not be liquid. The implication of this fact is that the value of assets
of the bank exceeds the value of the liabilities of the bank, but the bank has not employed its funds in liquid
assets, which might be converted into cash quickly and without loss. Liquidity depends on shiftability
without loss. It should not be sacrificed for higher profitability and excessive liquidity is also not necessary
as it will influence profitability adversely.
c) Profitability: a bank is a commercial organization. One of the objectives of a bank is to earn sufficient
profit. The bank must earn sufficient income from its assets so as to meet all its expenses and pay a fair
percentage of dividend to the share holders. The bank employs its resources to earn income, to pay
interest on deposits, to meet expenses of administration, to build up reserve fund and to pay dividend to
shareholders. The profits of the bank will be higher if the yield from the assets is greater. The bank
should determine the portfolio in such a way that it is able to derive maximum income. The bank should
invest its funds in those securities, which give higher yields. But it should be noted that in order to earn
higher yield, liquidity of the assets of the bank will have to be sacrificed.
d) Security or safety: a bank deals in the money of the public. It receives deposits from the public and
promises to repay the same along with interest at the predetermined rate. So a bank cannot afford to
invest its funds in risky adventures even though it may earn high income from such investments. A bank
is in the nature of the trustee of money belonging to public. It must ensure the safety of the funds of
depositors. That is why most of the banks invest their funds in Government securities and do not prefer
securities like shares and unsecured debentures.

In general banks to be profitable while being safe, it has to establish a balanced portfolio. It must
represent sufficient liquidity to meet the demands of the depositors and some portion of the funds should
also be invested in those assets are highly profitable. While choosing the assets for investment, bank should
not forget to see that it is a safe investment in the interest of the depositor and the bank itself. In Ethiopia,
the banks are required to keep minimum cash reserves of 15%of time and saving deposit and 5% of demand
liabilities. National Bank of Ethiopia has been empowered to regulate the required reserve ration that
individual commercial bank can maintain. While determining the structure of assets or at the time of
granting loans and advances, a bank should be guided by the three principles of sound investment, namely
liquidity, profitability and safety.

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