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Bank Credit

 

MEANING

Bank credit is the prime source of working capital finance. It represents the most important source for financing of current assets.

FORMS OF CREDIT

Banks in five ways provide working capital finance:

.Cash credits/overdrafts

.Loans

.Purchase/discount bills

.Working capital term loans

.Letter of credit

Cash Credit/Overdrafts

Under cash credit, the bank specifies a predetermined borrowing/credit limit. The borrower can draw up to the fixed Bank credit. Within the specified limit, any number of drawings is possible to the extent of his requirements periodically. Likewise, settlement can be made anytime during the period. The interest rate depends on the amount utilized by the borrower. However, a minimum charge may be payable on the unutilized balance irrespective of the level of borrowing for availing of the facility. This form of bank financing attracts the borrowers. This is because, firstly, it is flexible in that although borrowed funds are repayable on demand, banks usually do not recall cash advances. Secondly, the borrower has the freedom to draw the amount in advance as and when required, while the interest liability is only on the amount actually outstanding.

Loans

Under this arrangement, the entire amount of borrowing is credited to the current account of the borrower or released in cash. The loans can be repaid in periodic installments. They can also be renewed from time to time. As a form of financing, loans imply a financial discipline on the part of the borrowers.

Bills Discounted

Under this arrangement, Bank credit is being made available through discounting of bills by banks. In India, the RBI envisaged the progressive use of bills as an instrument of credit as against the prevailing practice of using the widely prevalent cash credit arrangement for financing working capital. The bill financing is intended to link credit with the sale and purchase of goods and, thus, eliminate the scope for misuse or diversion of credit to other purposes.

Before discounting the bill, the bank satisfies itself about the creditworthiness of the drawer and the genuineness of the bill. The discounting banker asks the drawer of the bill to have his bill accepted by the buyer before discounting it. The latter grants acceptance against the cash credit limit, earlier fixed by it, on the basis of the borrowing value of stocks. Therefore, the buyer who buys goods on credit cannot use the same goods as a source of obtaining additional bank credit.

Term Loans for Working Capital

Banks advance loans for at least 3-7 years that is repayable in yearly or half-yearly installments.

Letter of Credit

While the other forms of Bank credit are direct forms of financing in which banks provide funds as well as bear risk, letter of credit is an indirect form of working capital financing and banks assume only the risk, the credit being provided by the supplier himself.

The purchaser gets a letter of credit from the bank. In case the buyer fails to meet his obligations, the bank undertakes the responsibility to make payment to the supplier. The supplier sells goods on credit to the purchaser, and the bank gives a guarantee. The Bank credit bears risk in case of default by the purchaser.

MODE OF SECURITY

Banks provide loans on the basis of the following modes of security:

Hypothecation

Under this mode of security, the banks provide credit to borrowers against the security of movable property, usually inventory of goods. The goods hypothecated would continue to be in the possession of the borrower. The rights of the lending bank depend upon the terms of the contract between the borrower and the lender. Although the bank does not have physical possession of the goods, it has the legal right to sell the goods to realize the outstanding loan. The facility of hypothecation is not available to new borrowers.

Pledge

Under this mode of security, the goods that are offered as security are transferred to the physical possession of the lender. An essential prerequisite of pledge, therefore, is that the goods are in the custody of the bank. The temporary housing of the goods by the borrower is a kind of bailment to the lender. As a result, pledge causes a few liabilities for the bank. It must take sound care of goods. The term 'reasonable care' means care, which a prudent person would take to protect his property. He would be responsible for any loss or damage if he uses the pledged goods for his own purposes. In case of non-payment of the loans, the bank enjoys the right to sell the goods.

Lien

The term 'lien' refers to the right of a party to retain goods belonging to another party until a debt due to him is paid. Lien can be of two types: (1) particular lien, and (2) general lien. Particular lien is a right to retain goods until a claim pertaining to these goods is fully paid. On the other hand, general lien can be applied till all dues of the claimant are paid.

Mortgage

It is used as a method by which individuals can buy residential or commercial property without paying the full value upfront. The person who parts with the interest in the property is called 'mortgagor' and the bank in whose favor the transfer takes place is the 'mortgagee'. The instrument of transfer is called the 'mortgage deed'. The property becomes free from mortgage as soon as the debt is paid. Mortgages are taken as an additional security for working capital credit by banks.

Charge

Where immovable property of one person is made security for making payment to another person and the transaction does not result into mortgage, the latter is charged with all the provisions of simple mortgage. The provisions are as follows:

.A charge is not the transfer of interest in the property, though it is security for payment.

.A charge may be formed by the act of parties or by the operation of law. A mortgage can be formed only by the act of parties.

.A charge should not necessarily be made in writing but a mortgage deed must be attested.

.In general, a charge cannot be imposed on the transferee without notice. In a mortgage, the transferee of the mortgaged property can obtain the remaining share in the property, if any.

STYLE OF CREDIT

Till the mid-sixties, bank credit to industry had been exclusively in the form of the traditional cash credit system. The prevailing credit system suffered from the following drawbacks from the viewpoint of the banks:

.A bank did not exercise control over the level of drawings in the cash credit account. No notice was required for drawing under the limits, which may remain unutilized for long periods.

.A bank was not able to anticipate a demand for credit. This hampered its credit planning.

.The 'cost' of operations of the credit system to the banker, on account of the attendant uncertainties, was high because whatever chances he may take in 'overselling credit', there is always a limit up to which he could 'oversell'.

With a view to injecting discipline in the utilization of bank credit, modification was introduced initially in the structure. The modus operandi of the proposed system was that instead of making the entire credit limit available, it would be bifurcated into (1) loan, and (2) demand cash credit, subject to annual review. The loan component of the credit arrangement would comprise the minimum level of borrowings, which the borrower expects to use throughout the year. The cash credit component would consider the fluctuating requirements of the borrower.

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