Banking – Theory – Law and Practice Evolution of Banks by fanzhongqing

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             BBA 2.1

                    BANKING – THEORY – LAW AND PRACTICE
Evolution of Banks – Functions of Commercial Banks – Balance Sheet of Commercial Banks – Credit Creation,

Organization and structure of Banks – Unit Banking and Mixed Banking – Public Sector and Private Sector Banks –
Nationalization of Commercial Banks – Objects – Progress.

Central Bank – Evolution – Functions – Credit Control Measures

Money market – Indian money market – Components – Characteristics of developed and under developed money

Banker and Customer – General and Special relationships – Negotiable instruments – Features – Types of accounts
– Types of customers – Pass Book – Cheque – Features – Crossing – Endorsements

Paying banker – Duties – Holder in due course – Payment in the due course – Protection – Collecting banker – Duties
– Protection

Text and Reference Books:

1. Basu               :        Theory and Practice of Development Banking
2. Muranjan S.K.               :      Modern Banking in India
3. Reddy & Appanniah :         Banking Theory and Practice
4. Natarajan & Gordon :        Banking Theory and Practice

                                                    Lesson – 1
                                            EVOLUTION OF BANKING
                                         Evolution of Banking Institutions

Origin of the word “Bank”. – Opinion is divided in regard to this. According to some authorities, the work “Bank” itself
is derived from the words “bancus” or “banqee,” that is, a bench. The early bankers, the Jews in Lombardy,
transacted their business on benches in the market place. When a banker failed his “banco” was broken up by the
people, hence the word “bankrupt.” This etymology is however, ridiculed by Macleod on the ground Ages”. There are
others, who are of the opinion that the word “bank” is originally derived from the German word “back” meaning a joint
stock fund, which was Italianised into “banco” when the Germans were masters of a great part of Italy. This appears
to be more possible. But “whatever” be the origin of the word ‘bank’, “as Professor Ramchandra Rao says (Present-
Day Banking in India, 1st edition,p88) “It would trace the history of banking in Europe from the Middle Ages.”
       EARLY HISTORY OF BANKING – As early as 2000 B.C., the Babylonians had developed a banking system.
There is evidence to show that the temples of Babylon were used as banks, and such great temples as those of
Ephesus and of Delbhi were the most powerful of the Greek banking institutions. But the spread of irreligion soon
destroyed the public sense of security in depositing money and valuables in temples, and the priests were no longer
acting as financial agents. The Romans did not organize State Banks as did the Greeks, but their minute regulations,
as to the conduct of private banking, were calculated to create the utmost confidence in it. With the end of the
covilisaiton of antiquity, and as a result of administrative decentralization and demoralization of the Government
authority, with its inevitable counterpart of commercial insecurity, banking degenerated for a period of some centuries
into a system of financial makeshifts. But that was not the only cause. Old prejudices die hard, and Aristotle’s dictum,
that the charging of inerest was unnatural and consequently immoral was adhered to fanatically. Even now some
Mohammedans, in obedience to the commands contained in that behalf in their religious books, refuse to accept
interest on money loans. The followers of Aristotle’s dictum forgot that the ancient world, the Hebres included,
although it had to system of banks that would be considered adequate from the modern point of view, and maintained
moneylenders and made no sin of interest, but only of usury. However, upon the revival of civilization, growing
necessity forced the issue in the middle of the 12th century, and banks were established at Venice and Genoa,
though in fact they did not become banks as we understood them today, till long after. Again the origin of modern
banking may be traced to the money dealers in Florence, who received money on deposit, and were lenders of
money in the 14th century, and the names of the Bardi, Acciajuoli, Peruzzi, Pitti and Medici soon became famount
throughout Europe, as bankers. At one time, Florence is said to have had eighty bankers, though it could boast of no
public bank.

The Development of British Banking
ROYAL EXCHANGER – in England, we find during the reign of Edward III, money changing-an important function of
the bankers of those days-was taken up by a Royal Exchanger for the benefit of the Crown. He exchanged the
various foreign coins, tendered to his my travelers and merchants entering the kingdom, into British money, and, on
the other hand, supplied persons going out of the country with the foreign money they required.
THE GOLDSMITHS – It is probably true to say that the ground was prepared for modern banking in England, by the
influx of gold from America in the Elizabethan Age and the simultaneous growth of foreign trade. Land ceased to be
the only form of wealth, and the country gentlemen and the town merchants, began to hold part of their “capital” in
cash. Impetus was given to public banking by the seizure, by Charles I in 1640 of 130,000 bullion left for safe custody
by the city merchants at the Royal Mint. As a result of this Royal repudiation, the merchants began to entrust their
cashiers with large sums, but the later mis-appropriated their masters’ money for their own benefit. Finding that their
employees had not treated them better than their king, the city merchants decided to keep their cash with
goldsmiths,who in those days had strong rooms and employed watchmen.

EARLY REGINNING OF “ISSUE” AND “DEPOSIT” BANKING - Thus, large sums of money were left with the
goldsmiths for safe custody against their signed receipts, known as “goldsmiths’ notes,” embodying an undertaking to
return the money to he depositor or to bearer on demand. Two developments quickly followed, which were the
foundation of “issue” and “deposit” banking, respectively. The first was that the goldsmiths’ note bocmome payable to
bearer, and so was transformed from a receipt to a bank note. It was payable on demand, and enjoyed considerable
circulation. Secondly, the goldsmiths gradually discovered that large sums of money were left in their keeping for long
periods and, following the example of Dutch bankers, they thought it safe and profitable to lend out a part of their
customers’ money provided such loans were rapid within a fixed time. Further, realizing that the business of loaning of
other people’s money at interest was profitable, and in order to attract larger amounts, the more enterprising of the
goldsmiths began to offer interest on money deposited with them, instead of charging a fee for their services in
guarding their clients’ gold. This marks an important step in the development of banking in England. Business grew to
such an extent that it soon became clear that a goldsmith could always spare a certain proportion of his cash for
loans, regardless of the date at which his notes fell due. It equally became safe for him to make his notes payable at
any time, for so long as his credit remained good, he could calculate, on the law of average, the amount of gold he
needed to meet the daily claims of his note holders and depositors.

“CURRENT ACCOUNT”. – It was in 1672, that this development of English banking received a rude setback. Charles
II borrowed heavily from the goldsmiths and promptly like his father repudiated his debts. A crisis ensued, and was
followed by a general suspension of payments. Confidence, however, was restored in spite of the shock and the
general belief, which it produced among people that the goldsmiths were guilty of imprudence and exorbitant
practices. It was soon after this date that the goldsmiths found that they could receive money on what is now termed
“current account,” i.e., money withdrawal without notice.

The origin of modern banking in India dates back to 1770 when the first joint-stock bank, named the Hindustan Bank,
was started by the English Agency house of Alexander & Co, in Calcutta. The bank was, however, would up in 1832.

Presidency Banks
The real growth of modern commercial banking began in the country when the government was awakened to the
need for banks in 1806 with the establishment of the first Presidency Bank, called the Bank of Bengal, in Calcutta in
that year. Then followed the establishment of two other Presidency Banks, namely, the Bank of Bombay in 1840 and
the Bank of Madras in 1843. To each of these banks, the government had subscribed Rs. 3 lakhs to their share
capital. However, a major part of their share capital was contributed by the European shareholders. These Presidency
Banks, however, enjoyed the monopoly of government banking. They were also given the right of note-issue in 1823,
which was however, withdrawn in 1862.
These three Presidency Banks continued till 1920. In 1921 they were amalgamated into the Imperial Bank of India.

Indian Joint-Stock Banks

The year 1860 is a landmark in the history of public banks in India, since in that year the principle of limited liability
was first applied to join-stock banks. Since 1860 till the end of the nineteenth century, a number of Indian joint stock
banks come into existence. For instance, the Allahabad Bank was started at Allahabad in 1865. In 1875, the Alliance
Bank of Simla was started. In 1889, another Indian bank called Oudh Commercial Bank was established. In 1895, the
famous Punjab National Bank came into existence.
Inspired by the Swadeshi Movement, several Indian entrepreneurs ventured into the modern banking business.
During the boom period of 1906-13, thus, there was s mushroom growth of banks. Many prominent banks also came
into existence during this period. These were the Bank of India (1906), the Canara Bank (1906), the Bank of Baroda
(1908), and the Central Bank of India (1911).
Foreign Banks
In addition to the Indian joint-stock banks, a number of multi-national foreign banks called “exchange banks”, with
their head offices in their home countries, entered the banking system of India. Exchange banks were essentially
meant for financing the foreign trade of the country, but they also conducted banking activity in competition with
Indian banks. The exchange banks are termed “foreign banks”, because they were financed and managed by non-

Bank Crisis
Till about the middle of the twentieth century, Indian joint-stock banks had a checkered career in the country. The
banking sector experience severe set-backs during the priod-1913-17, as 108 banks failed and another 373 banks
failed on 1922-36 which was again followed by the failure of 620 more banks in 1937-38.
The Central Banking Enquiry Committee (1929) traced the following major causes of bank failure in India:
(1) Insufficient paid-up capital and reserves;
(2) Poor liquidity of assets;
(3) Combination of non-banking activities with banking.
(4) Irrational credit policy causing reckless and injudicious advances;
(5) Favouritism by the directors the their vested interests;
(6) Incompetent and inexperienced directors;
(7) Mismanagement;
(8) Dishonest management;
(9) Creation of long-term loans on the basis of short-term deposits;
(10) Indulgence in speculative investment;
(11) Ignorgance of the people about banking business;
(12) Lack of co-ordinate among joint-stock banks;
(13) Absence of a central bank for overall supervision and control;
(14) Lack of suitable banking legislation for regulation of banks.

And above all, the shattered public confidence in banks may be accounted for the failure of many Indian commercial
banks over time.Another event of bank failure took place in 1946-47, with the crash of the A.B.C. Bank, the Exchange
Bank of India and Africa and the Nath Banks.
        Eventually, at the time of Independence (in 1947), India inherited an extremely weak banking structure, with
the urban-orientation, comprising 544 small non-scheduled banks and 96 scheduled banks, giving bulk finance to the
trading sector. Moreover, only a few of them possessed on all-India character, while most of them had limited
geographical coverage in their business.

After independence, the Government of India launched economic planning in the country since 1951. During the last
37 years of the planning era, commercial banking has undergone drastic transformation through several important
developments/ reforms and policy measures introduced by the government.
Some of the major changes introduced in the Indian banking system may be enlisted as follows:
(1) Liquidation and amalgamation of banks;
(2) Nationalization of the Reserve Bank of India;
(3) Banking legislation;
(4) Evolution of public sector banking through bank nationalization.
(5) Declining significance of foreign banks;
(6) Structural changes of commercial banking;
(7) New strategies in banking business.

Banking : Definition
A banking company is defined a company which transacts the business of banking in India. The Banking Regulation
Act defines the business of banking by stating the essential functions of a banker. It also states the various other
businesses a banking company may be engaged in and prohibits certain businesses to be preformed by it.
The term ‘Banking’ is defined as “accepting, for the purpose of lending or investment, of deposits of money from the
public, repayable on demand or otherwise, and withdrawable by cheque, draft, order of otherwise” (Section 5(b)

         The sailent features of this definition are as follows:
(i) A banking company must perform both of the essential functions, viz., (a) accepting of deposits, and (b) lending or
investing the same. If the purpose of accepting of deposits is not to lend or invest, the business will not be called
banking business. The explanation to Section 5(c) makes it clear that any company which is engaged in the
manufacture of goods or carries on any trade and which accepts deposits of money from the public merely for the
purpose of financing its business, as such manufacturer or trader shall not be deemed to transact the business of
(ii) The phrase ‘deposit of money from the public’ is significant. The banker accepts deposits of money and not a
anything else. The word ‘public’ implies that a banker accepts deposits from anyone who offers his/her money for
such purpose. The banker however, can refuse to open an account in the name of the person who is considered as
an undesirable person, e.g., a thief, robber, etc. Acceptance of deposits should be the known business of a banker.
The money-lenders and indigenous bakers depend on their own resources and do not accept deposits from the
public. If they ask for money from their friends or relatives in case of need, such money is not deemed as deposit
accepted from the public.
(iii) The definition also specifies the time and mode of withdrawal of the deposits. The deposited money should be
repayable to the depositor on demand made by the latter or according to the agreement reached between the two
parties. The essential feature of banking business is that the banker does nor refund the money on his own accord,
even if the period for which it was deposited expires. The depositor must make a demand for the same. The Act also
specified that the withdrawal should be effected through an order, cheque, draft or otherwise. It implies that the
demand should be made in a proper manner and through an instrument in writing and not merely by verbal order or a
telephonic message.

It is thus clear that the underlying principle of the business is that the resources mobilized through the acceptance of
deposits must constitute the main stream of funds which are to be utilized for lending or investment purposes. The
banker is, thus, an intermediary and deals with the money belonging to the public. A number of other institutions,
which also deal with money, are not designated as banking institutions, because they do not fulfill all the above-
mentioned pre-requisites. The specialized financial institutions, e.g., Industrial Finance Corporation of India and State
Finance Corporation, are not banks because they do not accept the deposits in the prescribed manner. The essence
of banking business lies in the two essential functions. This is also evident from the definition given by Sir John Paget,
a noted authority on Banking.
Sir John Paget’s Definition: According to Sir John Paget, “No person or body corporate or otherwise, can be a
banker who does not (i) take deposit, accounts, (ii) take current accounts, (iii) issue and pay cheques, and (iv) collect
cheques, crossed and uncrossed, for his customers.” This definitions points out the four essential functions of the
banking business. Sir John Paget also lays emphasis on the performance of the above functions in a regular and
recognized manner. According to his, “one claiming to be a banker must profess himself to be one and the public
must accept his as such, his main business must be that of banking from which, generally, he should be able to earn
his living.” The above-mentioned function are considered as the essential functions of a banker but this definition
does not include the other functions which are now being performed by modern bankers.

Name must include the word ‘Bank’, ‘Banker’ or ‘Banking’. Section 7 makes it essential for every company carrying
on the business of baking in India to use as part of its name at least one of the words-bank, banker, banker, banking
or banking company. Besides, it prohibits any other company of firm, individual or group of individuals, from using any
of these words as parts of its/his name. Section 7 has been amended in 1983 with the effect that any of these words
cannot be used by any such company event “in connection with its business.”

                                                       LESSON – 2

                                        FUNCTIONS OF COMMERCIAL BANKS

  A commercial bank is a financial institution whose main business is to accept deposits from the public and to give
 loans to those who require it for short periods. The general functions of a commercial bank may be summarized as

1. Receiving of Deposits
The most important functions of the commercial banks is to receive deposits form the public. The commercial banks
not only protect them but also help transfer of funds through cheques and even undertake to repay the money in legal
tender money.
Deposits received by the commercial banks are of various types, - fixed deposits, savings deposits, current deposits
and recurring deposits. Fixed deposits or Time deposits are with the bank for a specified period of time and they can
be withdrawn only after the expiry of the said period. The interest rate depends on the time agreed upon. The longer
the maturity period, the higher the interest rate and vice versa. Form the point of view of safety and interest, fixed
deposits are preferable.
Savings deposits are those deposits received subject to certain restrictions. For instance, the interest is normally
lower on savings deposits; withdrawals may be made once or twice a week.
                  Current deposit or demand deposits as they the often called, are those deposits withdrawable by the
depositor at any time without any prior notice by means of cheques. The banks do not pay any interest on demand
deposits, but in fact make a small charge on customers with current account.
        Recurring deposits are those deposits received by the banks in equal monthly premium for a certain number
of years the total of which will be paid to the depositor with interest due thereon after the expiry of the date of maturity.
        Deposits at cal according to which deposits may be withdrawn when asked for by the depositor, deposits at
short notice by which depositors are required to give notice before certain number of days (7,21,30,45 or 90) for
withdrawal of deposits, short-time deposits for short period of a year or less for lower interest and retirement benefits
deposits, are some of the important forms of deposits received by the commercial banks.

2. Making loans and Advances
The second principal functions of the commercial bank is to make loans and advances out of the public deposits.
Direct loans and advances are given to all persons against personal security, gold and silver and other movable and
immovable assets. This the banks do by overdraft facilities, that is, by allowing the borrower or overdraw his current
account and also by discounting bills of exchange. The merchants and manufacturers enabled to obtain adequate
funds for production of goods and services. They help in the development of those industries which perform the most
useful service to the community.
The loans and advances made by the commercial banks are of various forms, like cash credit, overdraft, demand
loan, hire purchase loan, etc. Cash credit is that loan given by a commercial bank in installments against the security
of raw materials, produced goods, etc. Overdraft is made on security against stock and shares, insurance policies,
etc., under current account. Demand loan is paid in full to the debtor at a time. Hire purchase loans are made to all
persons for the purchase of customer durable goods like radio, bicycle, tailoring machine, sites for buildings etc and
these loans are repayable to the bank in easy installments with interest due thereon.

3. Agency Services
A commercial bank provides a range of investment services. Customers can arrange for dividends to be sent to their
bank and directly remitted into their bank accounts, or for the bank to detach coupons from bearer bonds and present
them for payments and to act upon announcements in the Press of drawn bonds, coupons payable, etc. Orders for
the purchase or sale of stock exchange securities are executed through the banks’ brokers who will also their
opinions on securities or lists of securities.
Similarly, banks will make applications of behalf of their customers for allotments arising from new capital issues, pay
calls as they fall due (that is, subscriptions to capital issues made over a period), and ultimately obtain the share
certificate or other documents of title. On certain agreed terms the banks will allow their names to appear on
approved prospectuses or other documents as bankers for the issue of new capital, they will receive applications and
carry out other instructions.
A commercial bank undertakes the payment of subscriptions, premia, rents and collection of cheques, bills,
promissory notes etc., on behalf of its customers. It also acts as a correspondent or representative of its customers,
other banks and financial corporations.
Most of the commercial banks have an executor and trustee departments; some may have affiliated companies to
deal with this branch of their business. They aim to provide, before, a complete range of trustee, executor, or advisory
services for a small charge. The business of banks acting as trustees, executors, administrators, etc., has
continuously expanded with considerable usefulness to their customers. By appointing a bank as an executor or
trustee of his will the customer secures the advantage of continuity, and avoids having to make changes; impartiality
in dealing with beneficiaries and in the exercise of discretions; and the legal and specialized knowledge pertaining to
executor and trustee services. When a person dies without making a will the next-of-kin can employ the bank to act
as administrator and to deal with the estate in accordance with the rules relating to intestacies. Alternatively, if a
testator makes a will but fails to appoint an executor, or if an executor is unable of unwilling to act, the bank can
usually undertake the administration with the consent of the persons who are immediately concerned. Banks will act
solely or jointly with others in these maters, as also in the case of trustee for stocks, shares funds, properties or other
investments. Under a declaration of trust, a bank undertakes the supervision of investments and distribution of
income; a customer’s investments can be transferred into the bank’s name of control, this enabling it to act
immediately upon a notice or rights issue, allotment letters, etc. Alternatively, where it is not desired to appoint the
bank as nominee, these services may still be carried out by appointing the bank as attorney. Where business is
included in an estate or trust, a bank will provide for its management for a limited period, pending its sale to the best
advantage as a going concern or transfer to a beneficiary.
Private companies wishing to set up pension funds may appoint a bank as a custodian, trustee and investment
adviser, while retaining the administration of the scheme in the hands of the management of the fund.
Most banks will undertake on behalf of their customers the preparation of income tax returns and claims for the
recovery of overpaid tax; they also assist the customers in checking of assessments. In addition to the usual claims
involving personal allowances and reliefs, claims are prepared on behalf of residents abroad, minors, charities, etc.

4. General Utility Services
These services are those in which the bankers position in not that of an agent for his customer. They include the
issue of credit instruments like letters of credit and travellers’ cheques, the acceptance of bills of exchange, the safe
custody of valuables and documents, the transaction of foreign exchange business, acting as a referee as to the
respectability and financial standing of customers and providing specialized advisory service to customers.

By selling drafts or orders and by issuing letters of credit, circular notes, travellers’ cheques, etc., a commercial
banker is discharging a very important function. A banker’s draft is an order, addressed by one office of a bank to any
other of its branches or by any one bank to another, to pay a specified sum to the person concerned. A letter of credit
is a document issued by a banker, authorizing some other banker to whom it si addressed, to honour the cheques of
a person named in the document, to the extent of a stated amount in the letter and to charge the same to the account
ofhte grantor of the letter of credit A letter of credit includes a promise by the issuing banker to accept all bills to the
limits of credit. When the promise to accept is conditional on the receipt of the documents of title to goods, it is called
a documentary letter of credit. But the banker will still be liable for bills negotiated before the expiry of the period of its
currency. ‘Circular letter of Credit’ is generally intended for travelers who may require money in different countries.
They may be divided into travelers letters of credit and guarantee letters of credit. A travelers letter of credit carries
the instruction of the issuing bank to its foreign agents to honour the beneficiary’s drafts, Cheques, etc., to a stated
amount which it undertakes to meet on presentation. While issuing guarantee letters of credit, the banker secures a
guarantee for reimbursement at an agree rate of interest or the may insist on sufficient security for the grant of the
credit, the banker secures a guarantee for reimbursement at an agreed rate of interest or he may insist on sufficient
security for the grant of the credit. There is yet another type which is knows as ‘Revolving Credit.’ Here the letter is so
worded that the amount of credit available automatically reverts to the original amount after the bills negotiated under
them are duly honored.

Circular Notes are cheques on the issuing baker for certain round sums in his own currency. On the reverse side of
the circular note is a letter addressed to the agents specifying the name of the holder and referring to a letter of
indication in his hands, containing an specimen signature of the holder. The not will not be honource unless the letter
of indication is presented. Travellers’ cheques are documents similar to circular notes with the exception that they are
not accompanied by any letter of indication. Circular cheques are issued by banks in certain countries to their agents
abroad. These agents sell them to intending visitors to the country of the issuing bank.
Another important service rendered by a modern commercial bank is that of keeping in safe custody valuables such
as negotiable securities, jewellery, documents of title, wills, deed-boxes, etc., Some branches are also equipped with
specially constructed strong rooms, each containing a large number of private steel safes of various sizes. These may
be used by non-customers for a small fee as well as by regular customers. Each licensee in provided with the key of
an individual safe and thus not only obtains protection for his valuables, but also retains full personal control over
them. The safes are accessible at any time during banking hours and often longer.
For shopkeepers and other customers who handle large sums of money after banking hours. ‘night safes’ are
available at many banks. Night safe take the form of a small metal door in the outside wall of the bank, accessible
from the street, behind which there is a chute connecting with the bank’s strong room. Customers who require this
service are provided with a leather wallet, which they lock before placing in the chute. The wallet is opened by the
customer when he calls at the bank the next day to pay the contents into his account.
Another function of great value, both to bankers and to businessman, is that of a referee as to the respectability an
financial status of the customer.

Among the services introduced by modern commercial banks during the last quarter of a century or so, the bank giro
and credit cards deserve special mention. The bank giro is a system by which a bank customer with many payments
to make, instead of drawing a cheque for each item, may simply instruct his bank to transfer to the bank accounts of
his creditor the sum due from him, and he writes one cheque debiting his account with the total amount. Credit
advices containing the name of each creditor with the name of his bank and the branch will be cleared through the
‘credit clearing’ of the clearing-house, which operates in a similar way as for the clearing of cheques. Even non-
customers of a bank for a small charge may make use of this facility. A direct debiting service is also operated by
some banks, This service is designed to assist organizations which receive large number of payments on a regular
basis. A creditor is thereby enabled with the prior approval of the debtor, to claim any money due to him direct from
the debtor’s bank account. To some organizations, for example, insurance companies, which receive, say, six equal
sums on six dated in a year, the scheme is only an ‘extension of the standing order facility; but for the public utilities
and traders which send out invoices for variable amounts at differing times, the scheme is an entirely new one.

Credit cards are introduced for the use of credit-worthy customers. Users are issued with a card on production of
which their signature is accepted on bills in shops and establishments participating in the scheme. The banks thereby
guarantee to meet the bill and recover from the cardholders through a single account presented periodically. In some
cases uses are required to pay a regular subscription for the use of the service as well. An extension of the scheme
allows the repayment of large sums (subject to a maximum) over a period at interest.

Some banks are opening budget accounts for credit-worthy customers. The bank guarantees to pay, for a specific
charge, certain types of annual bills (for example, fuel bills, rates, etc.) promptly as they become due, whilst
repayments are spread over a 12-monthly period from the customer’s current account.
All these new money transmission services have particular regard to the developments in computerized book-keeping
which the banks in some countries have already introduced. Some banks are reported to be experimenting with the
use of electronic machines which will scan cheques and dispense notes or coins, thus saving time at the counter.

Overseas Treading Services
Recognition of overseas trade has led modern commercial banks to set up branches specializing in the finance of
foreign trade and some banks in some countries have taken interest in export houses and factoring organizations.
Assisted by banks affiliated to them in overseas territories, they are able to provide a comprehensive network of
services for foreign banking business, and may transactions can be carried through from start to finish by a home
bank or its subsidiary. In places where banks are not directly represented by such affiliated undertakings, they have
working arrangements with correspondents so that banks are in a position to undertake foreign banking business in
any part of the world.
         The banks provide more than just a means for the settlements of debts between trades both at home and
abroad for the goods they buy and sell; they are also providers of credit and enable the company to release the
capital which would otherwise be tied up in the goods exported.

5. Information and other Services
         As part of their comprehensive banking services, many banks act as a major sources of information on
overseas trade in all aspects. Some banks produce regular bulletins on trade and economic conditions at home and
abroad, and special reports on commodities and markets. In some cases they invite enquiries for those wishing to
extend their foreign trade, and are able through their correspondents to furnish the names of reputable and interested
dealers of goods and commodities and to advise on the appointment of suitable agents. For businessmen traveling
abroad letters of introduction, indicating the purpose of journey taken, can be issued addressed to banking
correspondents in the various centers it is proposed to visit. In this way it is often possible to establish new avenues
of business. On request, banks obtain for customers, for business houses, confidential opinions on the financial
standing of companies, firms or individuals at home or overseas.
Commercial banks furnish advice and information outside the scope merely of trade. If it is desired to set up a
subsidiary or branch overseas (or for an overseas company to set up in the home country) they help to establish
contracts with local banking organizations.
         To sum up, the service rendered by a modern commercial bank is of inestimable value. It mobilizes the
scattered saving of the community and redistributes them into more useful channels. It enables large payments to be
made over long distances with maximum expenses. It constitutes the very life blood of an advanced economic
society. In the words of Walter Leaf: “The banker is the universal arbiter of the world’s economy.”
Commercial Banks and Economic Development
         Commercial banks have come to play a significant role in the development of countries. In fact, without the
evolution of commercial banking in the 18th and the 19th centuries, Industrial Revolution would not have taken place
in England. It will be equally true to state that without the development of sound commercial banking, underdeveloped
countries cannot hope to join the ranks of advanced countries. For, industrial development requires the use of capital
which will not be possible without the existence of banks to provide the necessary finance to acquire capital. Besides,
industrial development will be impossible without the existence of markets to dispose of the goods produced. But how
can markets be extended without the services of commercial banks?
         In this section, we shall deal with the important services provided by commercial banks and show how banks
play a significant role in the economic development of nations.
(i) Banks are necessary for trade and industry: All economic progress in the last 200 years or so has been based on
extensive trade and industrialization, which could not have taken place without the use of money. But money does not
mean coins and currency notes, only since these form only a small proportion of the total volume of money supply. It
is the bank deposits on which cheques can be issued that constitute the important sources of money. In all large
transactions, payments are not made in terms of money but in terms of cheques and drafts. Between countries, trade
is financed through bill so exchange which are discounted (i.e., bought) by banks. Without the use of the bank
cheque, the bank draft and the bill of exchange, internal trade and international trade could not have developed, and
without such trade, specialization and industrial development could not have taken place.
(ii) Banks help in distribution of funds between regions: Another way by which commercial banks encourage
production and enhance national income is by the transference of surplus capital from regions where it is not wanted
so much, to those regions where it can be more usefully and efficiently employed. This distribution of funds between
regions has the effect of opening up backward regions and paying the way for their economic development.

(iii) Banks create credit and help in business expansion: Fluctuations in bank credit have an important bearing on the
level of economic activity. Expansion of bank credit will provide more funds to entrepreneurs and, hence, will lead to
more investment. Under conditions of full employment, expansion of bank credit will have the effect of inflationary
pressure. But under conditions of unemployment, it will push up production in the country. On the other hand, a
decline in bank credit will result in decline in production, employment, sales and prices. From the view of an under-
developed economy, the expansion of bank credit offering more financial resources to industries in one of the
contributory causes for greater economic development.

(iv) Banks monetize debt: A very important service the banks render to he community is the creation of demand
deposits in exchange of debts of other (viz., short and long-term securities). Commercial banks buy debts of others
which are not generally acceptable as money, either because the debtors are not sufficiently known or because their
debt is payable only after a period of time. In return for them, they issue demand deposits which are generally
accepted as money. By these exchange operations, banks monetize debt. The significance of banks today flows from
the fact that they are “not merely traders in money but also, in an important sense, manufacturers of money.” Bank
money is used for the promotion of industry and trade. It is rightly said that they have not only the power to determine
the aggregate volume of bank money in existence but to influence the uses to which that money should be put.

(v) Banks promote capital formation: Commercial banks afford facilities for saving and thus encourage habits of thrift
and industry among people. The mobilize the idle and dormant capital of the community and make it available for
productive purposes. Economic development depends upon the diversion of economic resources from consumption
to capital formation. A higher rate of saving and investment is, therefore, what constitutes real capital formation. In
this, the role of banks is invaluable. But then there can be other institutions also in a country such as insurance
companies which may help in mobilizing the savings of the community for productive purposes.

(vi) Banks influence interest rates : Banks can influence economic activity in another way also. They can influence the
rate of interest in the money market through its supply of funds. By offering more or less funds, it can exert a powerful
influence upon interest rates. Besides, it can also influence the people to hold more less bank money or less or more
other assets. In this way, too, it can influence the interest rates. A cheap money policy with low rate of interest will
tend to stimulate economic activity, if other conditions are favourable.
In a developing country like India, banking facilities are highly inadequate. The vast number of people living in villages
and tows do not have any banking facilities and consequently all their savings are wasted. The opening of banks is
these areas or extension of bank facilities will help mobilize savings in these areas and, when put in the hands of
entrepreneurs, will become productive Besides in India commercial banks have started undertaking new functions to
help the private sector industries. They help in concluding deferred payments agreements between Indian industrial
units and foreign firms to enable the former to import machinery and other essential items.
         Thus, bans have come to occupy an important place in the industrial and commercial life of a nation. A
developed banking organization is a necessary condition for the industrial development of a country./
                                               LESSON – 3
                                   BALANCE SHEET OF COMMERCIAL BANKS

The Liabilities and Assets of a Bank : A Balance Sheet
        Banking is business much like nay other business. An indication of the financial position of a business
concern may be obtained by examining its statement of liabilities and assets, called the ‘Balance Sheet’.
        A balance sheet is always prepared in two sections. In one section it is customary to record liabilities,
normally on the left side, and assets in the other section on the right side. Liabilities are the debts or amounts of
money owned to others. The liabilities of a bank consist mainly of the claims of its shareholders, creditors and the
depositors. The assets, on the other hand, include such items as cash , accounts receivable, loans and investments,
A balance sheet always balances in total, but no individual items necessarily matches another. We can easily
understand this if we have some elementary knowledge of double-entry accounting. Any change in the one side of the
balance sheet must be precisely offset by an equal change in some other item on the other side. The equality of
assets and liabilities is not peculiar to banking alone. Every balance-sheet balances. But a bank’s business is, in a
very special sense, a balancing of assets and liabilities. A bank acquires assets by increasing its liabilities directly,
unlike any other business where liabilities are acquired indirectly as a result of trading. Thus, the first thing we want to
know about a bank and its operations is the amount of its debts and credits.

         The liabilities of the balance sheet of a bank is comparatively simple. The liabilities represent others’ claims
on the bank. The liabilities side of the balance sheet shows how the bank raises funds to function as a dealer in debts
and credits. The liabilities of a bank usually consist of the following items:

(1) Capital: The bank capital from its shareholders by issuing various types of shares, such as ordinary, preference,
deferred shares, etc. The balance sheet may show the amounts of authorized capital, issued capital, and subscribed
capital. But the actual liability of a bank to its shareholders consists of the capital originally paid in and any
accumulation of undistributed profits.

(2) Reserve Fund : It is the amount accumulated over the years out of undistributed profits. The bank may use this
fund to offset its unexpected losses in certain years. Sometimes a bank is required by low to transfer a part of its
annual profits to the reserve fund so long as amount in the fund does not become equal to its paid-up capital.

(3) Deposits: Deposits from the public constitute the biggest proportion of bank’s working funds. The deposits are
categorized as the demand deposits and the time deposits. It is the former that represents the bulk of the money
supply with public. It is on the basis of their deposit liabilities that the banks make loan and investments after keeping
ascertain cash reserve ratio.
Demand deposits are distinguished from time deposits. Time deposits are those against which cheques cannot be
written. Demand deposits may arise out of the credits created by a bank as a claim against itself. But in simple terms,
a customer is said to have “made a deposit” when he gives the bank cash or its equivalent and the bank gives him a
deposit credit. A deposit, therefore, is the promise that the bank gives the depositor in exchange for the cash he
“deposits”. The cash in an asset, the deposit is a liability. The depositor is a creditor of the bank having lent its cash,
and he can claim repayment at any time.

(4) Inter-bank borrowings : Liabilities are created when a bank borrows from another bank on a temporary basis. A
large bank, in particular, may have deposit liabilities not only for the account of the general public but also for other
banks in the country.
The bank may also borrow form the central bank of the country on the basis of the eligible securities or get financial
accommodation in times of need or stringency by rediscounting their bills of exchange.

(5) Liabilities relating to bills : The bank may have some bills which are payable by it out of its resources. It may also
accept some bills from its customers for collection. The amount when collected is credited to the accounts of the
customers. Hence the amount under this head is shown on both the sides of the balance sheet. They become the
liabilities of the bank after collection, but they are to be treated as assets before collection. The banks also accept of
endorse the bills of exchange on behalf of their customers, which simply means that the bank guarantees the
payment of bills at maturity. Thus, when the bank has accepted bills for its customers it is technically liable to meet
them on maturity, but since the customers are expected to meet them and have presumably given due security, this
liability of the customers to the bank is an offsetting asset against the acceptance.
         In addition to the above, the banks make some provision for the contingent or unforeseeable liabilities. The
profit earner by the bank is also shown as the liability because it is payable to the shareholders.
        It may be emphasized, however, that the assets of a bank are based on its liabilities. Banks, unlike other
business organization, acquire only a very small part of their total assets by issuing capital-account claims. An even
more important point is that the volume of capital-account claims or share capital changes only slowly and within
narrow limits relative to bank assets. Bank reserves, borrowings from other banks and the central bank are also very
small relative to total assets. Most of the assets of banks are acquired by creating and issuing bank credits in the form
of deposit claims. The volume of deposits that the banking system can issue depends on its reserve requirements
enforced by the central bank and the currency volume of reserves available to banks.

       We shall now briefly describe the main items of a bank’s assets in descending order or liquidity and
ascending order of profitability, and show how they reflect these two considerations.

1. Cash Balances
          The first asset in the portfolio of a commercial bank’s assets is cash-with itself and with the central bank of the
country. In certain countries, as in India, every commercial bank is required by law to keep some cash reserves
against its deposits. Cash is called the primary reserve of a bank. By experience a bank knows how much cash
reserves will have to be kept to meet the demands of depositors. Part of this cash is kept in the bank’s premises, a
certain portion with other commercial banks for purposes of inter-bank adjustments and a certain portion is kept as
deposit with the central bank of the country. A deposit with other commercial banks or with the central bank is
regarded as cash by a commercial bank. In India, commercial bank are obliged, by law, to keep a certain proportion
of total deposits in the form of cash reserves with the Reserve Bank of India.
The success of a bank depends upon the maintenance of sufficient cash reserves to honor the cheques presented by
the clients. But only a small percentage of depositors may be withdrawing their deposits through cheques and other
methods at any particular time. At the same time, if some are withdrawing, others may be depositing. A commercial
bank has therefore, to adjust its business in such a way that the amount of cash flowing in and the amount of cash
flowing out should be equal, keeping of course a margin of extra cash for the sake of safety. Too much of cash will
reduce the profit-earning capacity of a bank, at the same time, it should not keep too low cash reserves below the
minimum considered necessary or prudent.

2. Money at call and Short Notice
         Cash, being a barren asset, should not be kept beyond the minimum necessary for safety. But a bank may
feel that there may be a heavy pressure on its cash reserves due to seasonal changes in depositors’ and borrowers’
requirements. To meet this pressure, it may be borced to carry large cash reserves even in times when they are not
required at all. The other and better alternative for the bank is to keep some highly liquid but earning assets which can
be converted into cash quickly and without loss. There are two tyupes of such assets, viz., (a) call and short notice
loans to the brokers in the stock market., dealers in the discount market and to other banks, (b) short-term treasury
bills (borrowings of the government for short periods). These assets can be quickly converted into cash and without
loss, as a and when the bank wants. Hence banks regard such assets as secondary reserves as different from cash
which is their primary reserve. At the same time, these assets bring in some revenue income to the bank.

3. Short-term Bills
A commercial bank like to acquire assets which are for short period (generally for 90 days) and which are easily
marketable and hence sufficiently liquid and at the same time bring in some interest income to the bank. Such assets
are sometimes called “self-liquidating” because there is evidence of genuine commercial transactions, at the end of
which the necessary finance will be realized to repay the original loan. These self-liquidating bills consist mainly of
bills of exchange. A bill of exchange is written promises by a merchant, who has ordered certain goods, to pay a
specified sum of money on a specified sum of money on a specified date. This bill may be guaranteed by a bank or a
well-known merchant house-known in London as the Acceptance Houses. Besides commercial bills, there are short-
dated treasury bill through which the government borrows funds for short periods.

Commercial banks like short-dated paper or bill for a number of reasons : First of all, these assets are highly
negotiable and can be easily bought and sold. In countries like England, there is a special bill market in which these
bills are bought and sold (or discounted). Therefore, if a commercial bank requires additional funds, it can easily
rediscount the bills in the bill market or the discount market. Secondly, these bills are eligible for rediscounting with
the central bank of the country. That is, if a commercial bank wants cash, it can rediscount (or sell) the short-term bills
with the central bank. Thirdly, these bill bring in handsome interest for the commercial banks. Thus, commercial
banks prefers these short-dated bills because of their high marketability as well as their interest income; they are
regarded as ideal bank assets because they satisfy the twin considerations of liquidity and profit.

4. Loans and Advances

          The most profitable of all assets is bank loans and advances. This asset is universally sought after by banks.
Bank loans and advances may be made to businessmen either by the system of overdrafts of an agreed amount or
by discounting bills of exchange. Loans and advances carry a high rate of interest because of the risk involved, low
liquidity and the difficulty of shifting them. They involve great risk to the bank because of the possible failure of the
borrowers and in extreme cases because of their insolvency and liquidation. Again, these loans and advances have a
low liquidity and low shiftability in the sense that they cannot be converted into cash easily as and when the bank
requires additional cash to meet withdrawals, nor is there any possibility of shifting them to other banks or institution.
As a matter of fact, all bank failure may be ascribed to faulty policies regarding loans and advances. From the point of
view of safety of the bank and its liquidity, loans and advances are poor assets. But the high yield of these assets
compensates for the difficulties associated with them. These assets, thus, have low liquidity but high yield.

5. Investments

        Banks make investments in the profit-yielding securities. Investments in government securities represent the
book value of central and state government securities, including treasury bills and treasury deposit receipts etc.
Banks may make investments in other approved securities as well. The different types of investments are shown
separately in the balance sheet. Banks regard their short-term investments as their secondary reserves as different
from cash which is their primary reserve.

6. Properties

       Building, furniture and fixtures etc. are the other assets of the banks. These fixed assets are often referred to
as “Dead Stock”. They are generally shown at their depreciated value. These are, in a way, the secret reserves of the
banks which can be availed of in case of crises or collapse.

         The amount of assets that a bank can command depends upon the amount of its liabilities. Many types of
assets are available to a bank, profitless and profitable, liquid and non-liquid. A bank must therefore formulate a
portfolio policy determining what types and proportions of assets it will acquire and hold.

                                                       LESSON – 4

                                     COMMERCIAL BANKS : CREDIT CREATION

Control of Banks over Deposits

Bank deposits are of two types. There are current deposits which are used by businessmen, industrialists and others
to settle debts. These current deposits, in which cheques are issued, are also known as cash deposits or demand
deposits. The second type of bank deposits, which are not meant for current transactions, are known as savings
deposits. They are kept in bans as a form of savings or investments so as to earn interest from the banks. The
savings deposits are not held to meet the needs of the presents or the near future, but are kept by individuals as part
of their total stock of wealth, Savings deposits may also be known as time deposits. On type of savings deposits is
known as fixed deposits, i.e., deposits of money which can be withdrawn only after a given period of time.

The distinction between current deposits and savings deposits a matter of degree only. Money is kept in a bank for
the sake of convenience. It is used to meet excess of payments over receipts. Current deposits are useful to meet
payments immediately but savings deposits are kept to settle debts in future. In the case of current deposits the
depositor expects only convenience of payment of debts. In the case of savings deposits, however, the depositor
expects an interest income also.

        Who decides the distribution of deposits into current deposits and savings deposits? It is the customer who
decides whether he would prefer current deposits or savings deposits. Besides, if a depositor feels that he has too
large a volume of current deposits from which he is getting nothing, he may convert part of it into savings deposit.
Likewise, a customer with savings deposit may turn part of it into current deposit. The bank has nothing to do with

Primary and Derivative Deposits

        Deposits may be created in two ways:

         (a) People may deposit their cash with the banking system. i.e., they convert their cash into demand deposits.
One form of money (cash with the public) has been changed into another form of money (bank money). The initiative
for creating deposits is taken by he customers themselves. Such deposits are known as primary deposits. Apparently
the total volume of money remains the same through, in fact, it is not so.

          (b) Primary deposits bring cash to the banking system. Using this cash, the banking system buys assets from
the market (bills, bonds, debentures, etc.) or it lends to businessmen and industrialists. Now, whenever a bank buys
assets from the market or ends to certain parties, it does not give to them but creates demand deposits to their name.
These deposits are secondary or derived from the primary deposit-hence they are known as derivative deposits. The
initiative for creating deposits comes from the banking system. In a modern money economy, the second from the
deposits has become quite significant. When we say banks have control over deposits has become quite significant.
When we say banks have control over deposits, we mean that they have control over the total volume of deposits. Let
us see how the banking system is able to create the derivative deposits through acquiring assets.

Loans Create Deposits

        Money at call and short notice are extremely short-period loans made by a bank to speculators and brokers in
the money market and the capital market (i.e., stock exchange). The bank credits the deposit accounts of these
speculators and dealers for their promises to repay at call or short notice. The speculators and dealers would use
these deposits to pay off their creditors. The creditors who receive cheques or drafts credit them to their accounts.
Thus as a result of loan made by bank, deposits equal to the value of the loans have been created.

Bills discounted refer to the commercial bills and financial bills which are short-dated paper (generally for 90 days)
which a bank acquires from the bill market. When a bank buys (or discount) a bill of exchange from a party, it will
credit the account of the latter (if the party keeps an account with bank) or it will pay the party through a cheque on
itself. The party selling the bills will deposit the cheque in its bank account. In both cases, bank deposits will increase.

Bank advances, commonly known as loans, are made by the bank to industrialists, businessmen, traders and others.
When a loan is sanctioned, the bank creates a deposit in the name of the borrower. It allows the borrower to draw on
this deposit to pay off his creditors. In this case also, every loan a bank makes is creating a deposit. Naturally, the
banks create more deposits simply by making more and more advances.

Finally, investments are made by a bank when it purchases and holds Governments bonds and other securities which
have a longer life than three months. When a bank buys a bond from the Government, it places at he disposal of the
Government a bank deposit which the Government can use in any way it likes. If a bank buys an old Government
bond from the stock exchange, it will create a deposit in the name of the seller who is free to use the money in any
way he likes.

From what we have described above, it should be clear that every time a bank acquires an earning asset, it creates a
deposit in the name of the person or institution from whom the asset is purchased. The asset may be promise to pay
within a day or two or it may be a promise to pay within three months or it may be a Government’s I.O.U. to be
redeemed over a long period of time. Against the promises of individuals, institutions and the Government, which do
not constitute money the bank gives it own promise (viz, the bank deposit) which is money, i.e., it is creating money.
Two points should be mentioned here.
First, every asset acquired by bank an equivalent bank deposit. It is perfectly correct to state that bank loans create
deposits. Bank take the initiative to give loans and advances and acquire other earning assets: by doing go, they
control the total volume of deposits in the banking system.

Secondly, commercial banks monetize the debt of others. Against the promises of other to pay, the banks give their
own promises to pay. The former is not money but the latter is money. In this sense, banks create money.

Limitations to Creation of Deposits

An important question arises here. If a bank can buy assets just by giving its own promise to pay (i.e., bank deposits),
is there any limit to its buying of assets? Is there any limit to its creation of deposits? We are anwering this question
rather elaborately in the next section. One point, however, may be emphasized here. Against its deposits, a
commercial bank has to keep cash reserves. The proportion of cash to deposits may be fixed by law or its may be
determined according to convention and general usage. As the volume of earning assets increases, the volume of
bank deposits also increases but the ratio of cash deposits rises, business transactions will increase, giving rise to an
increase in price levels. People, therefore, will demand more currency notes for purposes of trade and exchange.
When the public draw out cash from banks, the ratio of cash to bank deposits will decline still further. The cash ratio is
thus, subject to decline on two rounds : (a) increase in deposits, and (b) drain of cash into circulation.

If the absolute size of the cash reserves with commercial banks in the country is given, the maximum amount of
deposits which banks can create will depend upon the cash reserve ratio to deposits. Suppose that commercial banks
have cash reserves of Rs. 100 crores and further the legal cash reserves ratio to deposits is 10 per cent. Then the
commercial banks can create and maintain deposits worth Rs. 1,000 crores. If the volume of bank deposits is less,
banks can acquire some more earning assets and increase the bank deposits also. Of course, it is assumed that
there are people willing to borrow from commercial banks. Suppose that the volume of deposits Rs. 1,200 crores
while the size of cash reserves in Rs. 100 crores. With legal cash reserve ratio at 10 per cent, commercial banks will
have to reduce their deposits by disposing of some of their earning assets. There will, thus, be a simultaneous decline
of bank assets and bank deposits, till the ratio of cash reserves to bank deposits becomes 10 per cent.

Thus the commercial banks have absolute control over the volume of bank deposits, subject or course to : (a) the
supply of cash, (b) the public demand for cash, and (c) the cash reserve ratio to be maintained. The central bank
enters the picture through its control of cash. By supplying more cash, the central bank can expect commercial bank
to increase their earning assets and increase their bank deposits. By reducing cash, the central bank can attempt to
achieve the opposite result.

The technique of Credit Creation

        Demand deposits or cash deposits are money are used as such, for every depositor having a current account
in a commercial bank can meet his obligations through cheques drawn on his account. Expansion or contraction of
deposits, therefore, means expansion and contraction of money in the country. Now, as indicated already, banks
have the power to expand or contract demand deposits and they exercise this power through granting more or less
loans and advances. Now, this power of commercial banks to expand deposits through expanding loans and
advances is known as credit creation.

         Bank credit really refers to bank loans and advances and creation refers to the multiplication of loans and
advances. As every bank loan creates an equivalent deposit, credit creation by the banks implies also multiplication of
bank deposits. The word creation’ is used to imply that bank are unique institutions and that they can create assets
(or give loans and purchase bills and bonds) out of nothing. Or with a small amount of cash, they are in a position to
acquire a large amount of assets.

        At one time, there was needless controversy regarding the ability of commercial banks to create credit. Some
writers meant by bank credit bank loans and investments and, therefore, maintained that bank could never and more
than the amount which it had been entrusted with by the depositors. Suppose that a person deposited Rs. 1,000
which a bank, the latter could lend up to Rs. 1,000 and not more. In fact, it should lend for less, since it had to
maintain a small margin of cash reserve against the withdrawal of money by the depositors. In any case the bank
could not lend more than Rs. 1,000 and, therefore, it was concluded that bank could not create credit.

          It is true that a bank cannot lend more than what it has got. But it is equally true that what is lent out by a bank
comes back to the bank by way of new deposits, which may again be lent out, and so on-deposit becoming the basis
for a loan or investment, which again returning to the bank as fresh deposit becomes the basis for a loan or
investment, which again returning to the bank as fresh deposit becomes the basis for a new loan, and so on.
Commercial banks, therefore, are able to multiply loans and investments and thus multiply deposits. A small volume
of cash is the basis for multiplication of deposits through multiplication of loans and advances (“loan create deposits”).
It is in this sense that banks create credit. Credit creation can be defined as the expansion of bank deposits through
the process of more loans and advances and investments.

Technique of Credit Creation

        Let us explain, in highly simplified manner, the technique or the process of credit creation by assuming:

        (a) the existence of a number of banks, A,B,C,D, etc., each with different sets of depositors:

        (b) Every bank has to keep 20 per cent of cash reserves, according to law; and

        (c) A new deposit of Rs. 1,000 has been made with bank A to start with

After the new deposit of Rs. 1,000 has been made in Bank A, the balance sheet of the bank (taking only the new
transaction) is as follows:
                                           Balance Sheet of Bank A

                        Liabilities                 Amount                      Assets                   Amount
                                                     (Rs.)                                                (Rs.)
          New Deposit                                  1,000    New Cash                                     1,000

                           Total                       1,000                                                 1,000

          Under the double-entry system the amount of Rs. 1,000 is shown on both sides. The deposit of Rs. 1,000 is
a liability for the bank since it is obliged to return the amount to the depositor whenever he demands. At the same
time, the amount is an asset to the bank which it may use to earn an interest income. Bank A has to keep only 20 per
cent reserve, i.e., Rs. 200 against its new deposit; it has a surplus of Rs. 800 which it can profitably employ. Suppose
that Bank A gives a loan to Mr. X who uses the amount to pay off his creditors. After the loan has been made and the
amount so withdrawn by Mr. X to pay ff his creditors, the balance sheet of Bank. A will be as follows :

                                                Balance Sheet of Bank A

                        Liabilities                 Amount                      Assets                   Amount
                                                     (Rs.)                                                (Rs.)
          Deposit                                      1,000    Cash                                           200
                                                                Loan to Mr. X                                  800
                           Total                       1,000                                                 1,000
        Now, the creditors of Mr. X, who got Rs. 800 from the latter, may be assumed to deposit the amount with their
bank, viz., Bank B. (This assumption is unnecessary, for the creditors of Mr. X may be banking with Bank A
depositing Rs. 800 with Bank A itself). The balance sheet of Bank B will be as follows:

                                              Balance Sheet of Bank B

                       Liabilities               Amount                    Assets                   Amount
                                                  (Rs.)                                              (Rs.)
                     New Deposit                      800                New Cash                        800

                         Total                        800                                                800

        After keeping a cash reserve of Rs. 160, (viz., 20 percent of Rs. 800), Bank B is free to lend the balance of
Rs. 640 to any one. Suppose that the bank buys bills worth Rs. 640.

        The balance sheet of Bank will be:
                                             Balance Sheet of Bank B

                       Liabilities               Amount                    Assets                   Amount
                                                  (Rs.)                                              (Rs.)
          Deposit                                     800   New Cash                                     160
                                                            Bills                                        640
                         Total                        800                                              1,000

         We can assume that the sellers of bills who received Rs. 640 from Bank B would be depositing the amount in
their bank, viz, Bank C. Bank C’s balance sheet will as follows:

                                              Balance Sheet of Bank C
                       Liabilities               Amount                    Assets                   Amount
                                                  (Rs.)                                              (Rs.)
          Deposit                                     640   New Cash                                     640

                         Total                        640                                                640

          Bank C finds that it has excess cash reserves to the extent or Rs. 512 (since under 20 per cent cash reserve,
it will have to keep a cash reserve of Rs. 128 only against a deposit of Rs. 640). Suppose that Bank C invests Rs.
512. Its Balance Sheet will be as follows

                                              Balance Sheet of Bank C
                       Liabilities               Amount                    Assets                   Amount
                                                  (Rs.)                                              (Rs.)
          Deposit                                     640   New Cash                                     128
                                                            Investment                                   512
                         Total                        640                                                640

         Now, Mr. Y who sold the long-term securities to Bank C for Rs. 512 may be expected to deposit the amount
with his bank, viz., Bank D, which in turn may keep 20 per cent as cash reserve and lend the rest. And this process of
a deposit becoming a loan or an investment which, in turn, becoming a new deposit goes on and on till the original
deposit of Rs. 1,000 is completely exhausted. The original deposit of Rs. 1,000 becomes additional deposits of Rs.
800, 640, 512, 410, 328, etc. If we add up all these deposits, the total will be Rs. 4,999.99 or Rs. 5000. This is the
process of deposit multiplication through the process of credit creation.

The formula of Credit Creation

As credit creation depends upon the ratio of cash reserves to deposits, the deposit multiplier is

        K    in which
        K  Deposit multiplier
        r  ratio of cash reserves to deosits
        If cash reservesratio is 20 per centr or 0.2, the deposit multiplier is
                1   1
        K            5
               20% 0.2

If cash reserve ratio is 10 per cent or 0.1 the deposit multiplier is 10, and so on. The higher the cash reserve ration,
the lower will be the deposit multiplier. The total deposit creation will be additional cash (M) multiplied by the deposit
multiplier. That is

Additional Aggregate Deposit (D) = M X K

If the commercial banks get fresh cash of Rs. 10 crores, as a result of Governemnt spending, they would be able to
multiply deposits through loans and investments to the extent or Rs. 50 crores (assuming a cash reserve of Rs. 20
per cent). That is

D       =        MXK
        =        Rs. 10 crores X 5
        =        Rs. 50 crores

So far, we have assumed that credit creation will take place when there are many banks. However, it is not really
necessary that there should be many banks, it is just sufficient that there is only one bank. Even then, the process of
credit creation will be the same. That is, whenever the bank ahs excess cash reserves, it will lend or invest the same;
this amount will come back to the bank in the form of a new deposit which will become the basis for yet another loan,
and so on. The money which goes out from the bank by way of loans etc., and the money concerned as to how a
depositor gets the cash which was with the bank a whole ago. Thus credit creation will take place, whether we
consider only one bank in an isolated town or we consider the banking system as a whole.

Credit Contractions

        Just as there is multiple expansion of deposits there is multiple contraction of bank deposits too, when cash is
removed from the banking system. Suppose there are a number of banks in the banking system. And each bank has
to keep a cash reserve ratio of 20 per cent against deposits. Let us further assume for the sake of simplicity that every
bank ahs a cash reserve of Rs. 10,000, total deposits of Rs. 50,000 and loans and investments worth Rs. 40,000.
Suppose that a depositor withdraws Rs. 1,000 from Bank A. The balance sheet of Bank A will be as follows:

                                                         Bank A

                       Liabilities                Amount                     Assets                   Amount
                                                   (Rs.)                                               (Rs.)
            Deposit                                 49,000    Cash                                       9,000
                                                              Loans & Investments                       40,000
                          Total                     49,000                                              49,000

Against deposit liabilities of Rs. 49,000 Bank A requires Rs. 9,800 as cash reserve, (This is 20 per cent of deposits).
But the Bank has only Rs. 9,000, leaving it with a deficiency of Rs. 800. The bank will make up the deficiency by
disposing of Rs. 800 worth of investments to someone who may be assumed to the banking with Bank B and who,
therefore, draws a cheque against Bank B in payment. After Bank A has collected the amount from Bank B, the
balance sheet of Banks A and B will be as follows:

                                                        Bank A
                       Liabilities               Amount                    Assets                   Amount
                                                  (Rs.)                                              (Rs.)
          Deposit                                  49,000    Cash                                       9,800
                                                             Loans & Investments                      39,200
                         Total                     49,000                                             49,000

                                                        Bank B
                       Liabilities               Amount                    Assets                   Amount
                                                  (Rs.)                                              (Rs.)
          Deposit                                  49,200    Cash                                       9,200
                                                             Loans & Investments                      40,000
                         Total                     49,200                                             49,200

From the balance sheet of Bank A, it will be clear that by disposing of some investments it has been able to restore
itself to a satisfactory position. However, the balance sheep of Bank B shows a reduction of Rs. 800 from its deposits
and of the same amount from it cash. This account has been paid to Bank A against the sale of investments of Rs.
800. Bank B is now deficient of cash to the extent of Rs. 640. (It requires Rs. 9.840 against total deposits of Rs.
49,200; but it actually has Rs. 9,200 only) To make up the deficiency, Bank B will sell some of the investments to
some one who may be banking with Bank C, and who issue cheque against Bank C in payment. After Bank B has
received the payment from Bank C, the balances sheets of the two banks will be:

                                                        Bank B

                       Liabilities               Amount                    Assets                   Amount
                                                  (Rs.)                                              (Rs.)
          Deposit                                  49,200    Cash                                       9,840
                                                             Loans & Investments                      39,360
                         Total                     49,200                                             49,200
                                                       Bank C

                       Liabilities               Amount                    Assets                   Amount
                                                  (Rs.)                                              (Rs.)
          Deposit                                  49,360    Cash                                       9,360
                                                             Loans & Investments                      40,000
                         Total                     49,360                                             49,360

 Bank B has adjusted itself, but bank C has deficiency of cash which it will make up by deposing of its investments or
by contracting loans. This process goes on till al the effects are fully exhausted. Thus the original reduction deposits
by Rs. 1,000 from Bank A is followed by reduction of deposits by Rs. 800 from Bank B, of Rs. 640 form Bank C, and
so on. The process of contraction of Bank deposits in the same as that of expansion-only in the reserve direction.

Limitations on Credit Creation

        Theoretically, the banking system can create an unlimited amount of money by way of expansion of deposits.
However, there are creation factors on which the volume of credit creation depends. It is not possible, rather it is
dangerous, to attempt credit expansion beyond a creation limit.

         (i) Amount of cash held : The firs important factor on which the extent of credit creation depends is the
amount of cash which commercial banks posses. We have shown that banks have to redeem their demand deposits
in coins and currency notes at the request of their depositors. Fialure to do so will mean instantaneous failure of the
bank. The larger the amount of cash with the banking system, the larger will be the credit creation. As Crowther puts
it, “The bank’s cash in the lever with which the whole gigantic system is manipulated.”

         (ii) Ratio of cash reserves : The required ratio of cash reserves to deposits is another important factor on
which the volume of credit creation will depend. We have shown that credit creation will be the reserve of the cash
reserve ratio. If a bank considers or the law requires that cash reserve equivalent to 10 per cent of deposits should be
kept as cash, the bank may expand the amount of its deposits to 10 times the volume of its cash resources, if a bank
is required to keep 20 per cent cash reserve against its deposits, credit creation will be to the extent of 5 times only.
Thus, he higher the percentage of cash reserve ratio to be kept, the smaller will be the volume of credit creation.

        (iii) Public’s desire to hold cash : Credit creation depends upon the amount of cash with the banking system
which will in turn depends upon the desire of the general public to hold cash. If for any reason they decide to have
more cash (assuming the total amount of currency notes and coins to be constant), the banks will be left with a
smaller amount of cash and thus credit creation will be smaller. In fact, large expansion of deposits will add to the
total amount of money supply in the country and this will be accompanied by an increased volume of business, rising
prices, wages, retain trade, and so on. The depositors will like to keep more cash in the form of coins and currency
notes. This will mean reduction in the volume of cash reserves with the banks.

        (iv) Nature of business conditions in the country : Credit creation will depend upon ht nature of business
conditions. Credit creation will be large during a perious of business prosperity while it will be smaller during a
depression. In periods of business prosperity, there will be more demand for loans and advances for investment
purposes. And as we have seen, expansion of deposit depends upon the volume of bank loans and advances.
Therefore, during periods of business prosperity, many people approach banks for loans and advances and hence
the volume of bank credit will be high. Besides, the banks are willing to lend freely during such periods because of the
general optimism and the high percentage of returns.

        During periods of business depression, however, the amount of loans and advances will be small
businessmen and industrialists may not come forward to borrow in this period. Besides, banks may prefer to keep
excess reserves and sacrifice earnings. There can be many reasons for this.

        (a) Banks may anticipate a possible loss of depositor’s confidence in them and therefore, of possible run on

       (b) They may not be sure about the ability of borrowers to repay, In depression, the credit is contracted, partly
because of deficiency of sound investments of borrowers and partly because proper securities are not available.

        (c) They may be afraid of falling prices of securities. Hence they may not like to invest in them. Thus, they
may elect to hold more cash reserves with themselves and may not expand credit to the maximum extent, but in
normal times we can expect them to lend and invest up to the maximum extent permitted by their cash reserves.

        (v) Leakages in credit creation : There may be a difference between the maximum potential credit expansion
and the actual expansion because of certain leakages in credit creation. These leakage have been actually omitted in
our simple example of credit creation given above. The important leakages are:

       (a) The banks may not be able to make loans and investments exactly according to the surplus funds they
may have. For example, if a bank has a surplus fund of Rs.800, it is not necessary that the exact amount of Rs. 800
may be lent out. To the extent that the actual loan is short of Rs. 800, credit creation will be smaller.

(b) The amounts of advances made by the banks have been assumed to return to them by way of new deposits. But
 they may not, as the public may wish to hold some cash with themselves. Again, therefore, the new deposits every
        may not be by full amount of the loans made earlier. Credit creation, therefore, will be limited again.

          (iv) Monetary policy of the central bank. The extent of credit creation will largely depend upon the monetary
policy of the central bank of the country. For one thing, the central bank has the influence the volume of money in the
     country and for another, it can directly or indirectly influence the banks power to expand or contract credit.

                                  Significance of Credit Creation and Contraction

           Bank deposits in modern communities form the predominant type of money and hence expansion of bank
 deposits means expansion of money supply, and contraction means contraction of money supply. But fluctuations in
   the volume of money supply have a direct effect on the level of business activity, prices and wages. An increase in
the volume of credit, by leading to an increase in the money supply, will lead to a rise in prices and profit margins and
consequently increase in business and economic activity. On the other hand, contractions, of bank credit will result in
  contraction of business activity. At one time, the expansion and contraction of credit were given the pride of place in
 the explanation of business cycles and also in any policy designed to control them. But, these days, they are given a
      secondary importance only. That is, very may not be responsible for prosperity or depression but when once
     prosperity or depression starts, credit expansion contraction accelerates the tempo of cyclical fluctuations. The
  expansion of bank credit to the maximum extent may “boom the boom”, while the failure to create as much credit as
                                    their reserves permit may “depress the depression”.

       Whether credit expansion (and contraction) plays are primary role or only a secondary role in the causation of
    cyclical fluctuations, it is but obvious that any policy designed to bring about business stability should include
                          measures to bring about stability in credit expansion and contraction.

                                                      LESSON – 5

                                   ORGANISATION AND STRUCTURE OF BANKS

                                                Banking Organisations

1. Private Individuals

         Law does not prohibit a private individual from carrying on banking business. His main difficulty would be to
attract depositors in the present days when there are reputed big banking companies and corporations in the private
and public sectors. The maximum number of depositors have also been restricted under the Reserve Bank of India

        Prohibition of acceptance of deposits by unincorporated Bodies – Chapter IIIC has been INSERTED IN THE
Reserve Bank of India Act, 1934 by the Banking Laws (Amendment) Act, 1983 with effect from 15.2.1984 containing
sections 45R, 45S and 45T. Section 45S provides that no person, being an individual or a firm or an unincorporated
associations of individuals shall have deposits from more than following number of depositors:

               (i) Individual                            Not more than 25 depositors excluding
               (ii) Firm                                 Not more than 25 depositors per partner and
                                                         not more than 250 in all, excluding relatives of
                                                         any of the partner.
               (iii) Unincorporated association of       Not more than 25 depositors per individual and
               individuals                               not more than 250 in all, excluding relatives of
                                                         any of the individuals.

Sub-sections 2 provides that where at the commencement of the Act number of depositors, exceed the above limit,
the person shall repay within 2 years such number of depositors to bring them within the limits specified.

         (a) a person shall be deemed to be a relative of another if, and if, - (i) they are members of a Hindu undivided
family, or (ii) they are husband and wife, of (iii) the one is related to the other in the manner indicated in the list of

        (b) a person in whose favor a credit balance is outstanding for a period not exceeding 6 months in any
account relating to mutual dealings in the ordinary course of trade or business shall not, on account of such balance
alone, be deemed to be a depositor.

         In Kanta Mehta V. Union of India and others, (1987), the Delhi High Court has held that section 45-S (read
with section 48B(5A) of Chapter III-C of the Reserve Bank of India Act, 1934, as introduced by section 10 of the
Banking Laws (amendment) Act, 1983, which imposes a ceiling on depositors in the case of Individuals, Firm and
Association is not discriminatory and does not affect he fundamental right to carry on business or to form association
or unions. It is not violative of Articles 14 and 19 of the Constitution, There is nothing demonstrably irrelevant or
perverse in limiting the number of depositors that an individual, form or association could accept. Nor is there any
element of compulsion on individuals and firms or associations which are not incorporated to incorporate themselves
as a company. Chapter III-C imposes reasonable restrictions on the right of individuals firms and unincorporated
association to carry on the business of acceptance of deposits and advancing or giving loans to the public. There is a
further safeguard that Chapter III-C is being operated under the supervision and control of the Reserve Bank of India.
         Section 45T further provides that an officer of the Reserve Bank or the State Government, authorized in this
behalf, may obtain a search warrant from courts so as to enable them to enter into and search any premises
suspected to be used for the purpose connected with the receipt of the deposits in contravention of sections 45S.
Such warrant shall be executed in the same way and shall have the same effect as a search warrant issued under
the Code of Criminal Procedure, 1973.

II. Partnership Firms
         A firm with more than ten partners cannot carry on banking business : it has to be registered as a company
(Section 11(1) of the Companies Act, 1956). A banking firm of ten partners or less faces the same difficulties as an
individual would face.
         The law relating to Partnership Firms is laid down in the Indian Partnership Act, 1932.
III. Hindu Joint Family System

           A many places in India other than cities banking business was carried on by private banks owned by joint
Hindu Families. The most prominent among these are the VAishya, the Jain and the Marathi families scattered all
over India, the Nattukottai Chettys in the State of Madras; the Khatries and the Auroras in Punjab, and the Multanies
in Gujarat and the Uttar Pradesh. This system bears striking resemblance to our modern joint stock banks in more
than one respect. Its lie is institutional, and not personal, and as such, it enjoys unbroken continuity, it has a distinct
existence in law and the going out or the coming in of persons makes not the slightest difference to the continuity of
that body. The concept of Joint Hindu family is recognized by law. A business, according to that law, is a distinct
heritable asset. Where a Hindu dies leaving a business it asses like other heritable properties to his heirs. If he dies
leaving male issues it descends to them. In the hands of the male issues it becomes Joint Family business and the
firm which consists of the male issued becomes a joint family firm (Mulla’s Hindu Law). The joint ownership is not an
ordinary partnership arising out of contract but a family Partnership created by the operation of Law. The rights and
liabilities of the co-partners constituting the family firm as also of the persons dealing with the firm are not to be
determined by exlusive reference to the Indian Partnership Act but are to be considered with regard to certain rules of
the Hindu Law.

IV Banking Companies and Corporations

The bulk of banking business now in India is carried on by scheduled banks which are the Banking Companies and
the nationalized Banks. Bulk of the banking business in the country is in the public sector. There are altogether 27
banks in the public sector, comprising the State Bank of India and its 7 associate banks, 19 commercial banks
nationalized in July 1969, and in April 1980. The public sector banks account for about 90% of the total banking
business in India.

        The provisions regulating the formation, management and administration of the banking companies in the
Private sector are laid down in the Banking Regulation Act (previously known as the Banking Companies Act, 1949).

       The Board of Directors of banking company in the private sector is to be constituted under section 10A of the
Banking Ac.

       The Chief Executive of such a banking company is the private sector is to be constituted under section 10A of
the Banking Regulation Act.

        The 19 banks in the public sector have their own directors appointed by the Central Government under the
provisions of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970 and 1980.

Unit Versus Branch Banking

         The structure of banking differs from country to country depending upon the socio, economic and political
conditions. Broadly speaking, there are two types of banking systems-branch banking and unit banking. There was a
growing controversy among economist and bankers as to the relative superiority of the two banking systems. Even
now the echo of the controversy has not altogether passed away. The controversy has, however, no practical

Branch Banking

       The branch banking system is a system in which every commercial bank has a network of branches operating
throughout the country. Every bank is a separate legal entity and ahs one board of directors and one group of

Merit of Branch Banking

Branch banking has certain definite advantage over unit banking. The following are some of them.

1. Advantage of the large scale - operations

       Firstly, the branch banking system has the advantages of large –scale operations. R.S. Sayers is also of the
same view. Efficiency in administration, economy in working, effective central banking control, etc., are some of the
important advantages of having branch banking system. The banking functions can be divided into a number of
departments and placed under different individuals or groups of individuals. Bank officers can be given management
and supervisory training at the training centres established for that specific purpose. Expert advice from the head
office is always available to all the branches.

2. Economy of reserves

         Every bank is supposed to keep a certain of its total deposits as cash reserves in order to gain and retain the
public confidence at large. But profitability is an opposing consideration. The greater the amount of cash with the
banks, the lesser the profitability and the lesser the amount of cash with the banks, the greater the profitability. In
branch banking, however, the existence of a large number of branches enables a bank to keep the reserves at as low
a level as possible so that the profit-earning capacity of the bank would not reduced.

3. Proper distribution of capital

         Branch banking makes possible the movement of capital from one place to another through the branches of a
bank. Because of such transfers of capital, there are certain advantages. Firstly, funds can be transferred from those
places where they are abundant to those places where they are scarce. Secondly, the disparities in the different rates
of interest ruling at different places can be largely mitigated. Thirdly idle capital in one lace can be transferred to
another place where it can be profitability invested. Fourthly, capital is put to the most productive use. Lastly, the
profit-earning capacity of the bank is greatly increased.

4. Loans and advantages given on merits

         Under the system of branch banking, local influential, but not credit-worthy persons cannot secure any loans
or advance from the bank because the branch manager can always shift the responsibility of refusal on to the head
office at a far off city. This is because loans and advances are made on the basis of merits f the purposes for which
they are sought by the customers.

5. Remittance business made easy

When the bank has several branches in different places, remittance business can be performed with great ease or
with little difficulty.

6. Benefit to small communities

        Even small communities enjoy the advantage of the services of the more powerful and sunder banks.

7. Geographical spreading of risks

         When a bank has its branches at different localities, it can minimize its risks because the losses incurred in
depressed areas can be offset by the profits earned in prosperous areas. For example, when English banks incurred
heavy losses due to the depression in the cotton textile industry in Lancashire in 1929, the losses were made up by
the profits earned in other areas. Thus risks can be spread all over the country under branch banking system.

8. Large financial resources

        The financial resources of branch banks are of greater magnitude. Hence, the requirement of large customers
can be easily met; loans and advances can be made on more liberal terms; and they are capable of withstanding
greater shocks. Thus the branch banking has a sound and strong financial stability.

Demerits of Branch Banking

        The system of branch banking has many disadvantages. The following are some of them.

1. Delay in transactions

        The branch managers do not have adequate powers in granting large loans and they have to get the approval
of the head office before transacting such large business. This means delay. But this arguments is not valid in these

days because the branch managers are in close touch with the head office through telephone and telegram.

2. Lack of sympathy for local needs

The branch managers do not have any knowledge about the local condions or local problems and difficulties or local
borrowers. This is perhaps, due to the frequent transfer of branch managers. Therefore the banch banking system
does not sympathise with the local needs.

3. Funds of a region use elsewhere

        Funds of one region or locality may be used in other regions or localities.

4. Creation of monopoly power

       The branch banking system creaters some sort of monopoly power. Under branch banking, there is
concentration of financial resources in the hands of a few banks which results in the creation of monopoly.

5. Competitive waste

        Due to keen competition between the branches of different banks in one region or locality, there is found to
be a large wastage of time, energy and financial resources of the region or locality.

6. Preferential treatment shown to nearby firms

        The branches of the banks show a good deal of preferential treatment to those firms which are situated
nearby the branches detrimental to the growth of firms at far off places.

7. Supervisory problems

       In branch banking, there are many supervisory problems in matters of managing and controlling the far-flung
branches of the bank. In the branch offices, there is an ever-present danger of mis-management.

        Thus the system of branch banking has both many advantages as well as disadvantages of its own.

Unit Banking

           A unit banking system is a system in which the business of each bank is confined to a single office which has
no branch at all. Each banking company is a separate company, separately licensed, having its own capital, board of
directors and shareholders. Generally, there is only one place of operation. However, there may be branches within a
strictly limited area. The area of the operation of the bank as well as the size of the bnak are smaller.

Merit of Unit Banking

        Unit banking system has also some important merits of its own.

    (a) Resources of the locality are used for the economic development of the locality and are not transferred to
        other areas.
    (b) The unit banker has specialized knowledge of the local industries and occupations, customs and prejudices.
        He can serve the local needs of the small communities in an effective manner. In fact, he pays great attention
        to the financial problems and needs of the individual enterprises in his area.
    (c) Since the affairs of the bank are less scattered, there are very few possibilities for fraud and irregularities,
        management and supervision do not offer any serious problems.
    (d) Unit banking is free from the diseconomies of large-scale operations which are generally associated with
        branch banking.

Disadvantages of Unit Banking

        Among the disadvantages of unit banking, the most important is that a unit bank has limited financial
resources and, therefore, cannot withstand a business depression or a run on it. A very important factor which
contributes to the low survival rate of a unit bank is its lack of diversification of deposits and assets and specialization
in those industries which are located in the area. Any difficulty in these industries will automatically land the bank also
in difficulties. In fact, during the Great Depression of 1930’s so many unit banks failed in the U.S.A. – nearly 5,100
banks – that it became clear that such banks were ill-equipped to withstand adversity.

          Another demerit of unit banking is that it is not able to provide full and adequate banking facilities to small
communities because the area of its operations is restricted and the unit bank may not command adequate
resources. Inadequacy of financial resources is responsible for the inability of unit banking system to support an
efficient management.

Lastly, the unit banker, being a local man, may have to follow considerations other than strict eco0nomic principles in
granting loans and advances. For instance, it may be very difficult and even dangerous for the banker to refuse an
influential local businessman who may not be so creditworthy. If he lends, the businessman may default and land the
bank in difficulties, and if the loan is refused, the unscrupulous businessman may circulate remours about the
solvency of the bank and thus bring about the bank’s failure. To sum up, it is agreed that the branch banking system
has far more substantial merits and has greater power of survival than the unit banking system. Even in America,
traditionally considered as the home of unit banking, the trend since 1930’s has been towards branch banking, or to
get the advantages of branch banking by what are known as group banking and chain banking system.

Other Banking Systems

        There are three other types of banking system also, viz., the group, the chain and the correspondent banks.

        Group banking is one where two or more separately incorporated banks are brought under the control of a
holding company which may or may not be a banking company. The banks so brought together may be unit banks or
branch banks or both.

        Chain banks refer to separately incorporated banks brought under common control by a device other than the
holding company. This may be through some persons being directors of two or more banking companies or same
groups of persons owning them.
        Under the correspondent banking system, banks are linked together through deposits by smaller banks of
some of their cash reserves with bigger banks. Here the bigger banks with which deposits are so made are called
correspondent banks. These banks in turn may deposit some of their cash balances with still bigger banks in
metropolitan cities. The correspondent banks have expert consultants whose services can be utilized by other banks
depositing cash. The correspondent banks also transfer cash balances of banks.

        All these three types enable some of the advantage of branch banking to be enjoyed even by unit banks.

Deposit Banking Versus Mixed Banking

         Banks and other institutions are classified into deposit banks, investment banks and mixed banks. This
classification of banks was made on the basis of the functions that the banks perform. A very rigid functional
classification is not only very difficult, but also very unrealistic. However such a classification is necessary to
understand and appreciate the nature and functions of different banking institutions.

Deposit Banking

        Deposit Banking is that system of banking in which the commercial banks pool together the savings of the
community and make them available for short-term credit productive undertakings. The commercial banks perform
two important functions – of attracting public deposits and of lending them for traders, industrialists and other for short
periods by means of advances, overdraft facilities, discounting bills, etc. The public deposits with the commercial
banks are repayable on demand or at short notice and hence they are lent only for short periods of time to provide
only short-term finance or working capital to industries for purchase of raw materials, payment of wages and salaries
to workmen, etc. If the commercial banks were to invest these funds in loans extending over long periods of time, the
commercial banks will cease to functions both as the custodians as well as trustees for the hard earned money of the
vast majority of the depositors. Mackenzie, while describing the deposit banking, writes thus: “The policy of our banks
has always been to made advances to trade and industry for current and seasonal requirements and for short periods
and not to lend capital for an indefinite term – departure from this policy is attended with risk.”

Deposit banking will prove to be a good system only when the following conditions are present.

        a) The existence of adequate facilities and good financial machinery of capital market to provide for the fixed
           capital requirements of industries is a prerequisite for the successful operation of deposit banking in a
        b) The banks should not lock up their financial resources for long periods.
        c) Intelligent investors with adequate stock of financial resources should be present in the country.

        These are the essential conditions for the successful operation of deposit banking. England has all these
conditions before 1914. As a result, only pure deposit banking developed there.

Industrial Banking

         Industrial Banking, also known as investment banking is that system of banking in which the banks play a
significant role in the industrialization of the country by providing the longer term capital for establishment, expansion
and reorganization of industries in the country. The loanable funds of the industrial banks consist of paid-up capital
and long-term debentures and hence are not repayable on demand or at short notice.

        The German banks in the period 1848-1870 offer a good example of industrial banking system. In this period,
a series of banks were established in Germany with the primary objectives of promoting industrial development by
establishing new companies and by consolidating the existing concerns.

       The industrial or investment banks had the following advantages. In the first place, the representative of the
banks acted on the Board of Supervisors of industrial concerns in order to safeguard the interest of the banks.

         In the second place, the banks avoided the risks involved in the provision of long-term finance by making
every line of their activity self-balancing. This they could well do by using short-term financial resources (deposits) for
short term loans and long terms financial resources (capital and reserves) only for long-term loans.

        In the third place, the industrial banks has a good amount of large capital and reserve resources. They were,
therefore, in a better position to provide long-term finance for industries.

         In the fourth place, the banks acted as an association known as Consortium or Syndicate thereby spreading
the risks over a number of banking companies.

        In the fifth place, the banks were in a special and advantageous position to perform useful functions to

       In the last place, the German banks had very high order of management. Competent experienced and honest
men became the managers of the banks.

Making Banking

        Now-a-days, the trend has been towards the establishment of mixed banks. Mixed banking system is that
system of banking which combines deposit (commercial) banking and industrial banking. In other words, where the
commercial banks themselves act as industrial banks, they are known as mixed banks. The mixed banks attract
deposits fro the general public and provide short-term, medium-term and long-term capital to industries. This mixed
banking is the most common form of banking everywhere Germany, Austria, Switzerland and Italy are good examples
of countries having mixed banking system.

         In India, there has been a long-standing controversy between two groups of men, one for introducing mixed in
India and the other against it. The advocates of mixed banking in India were very much influenced by the rapid
industrialization of Germany in the last quarter of the 19 century. Therefore they recommended the introduction of
mixed banking in India for a rapid industrial development in India. But the antagonists were strongly against the
establishment of mixed banking in India. They listed down the following arguments against mixed banking. Firstly, the
small size of banks and their meager capital resources do not warrant the undertaking of risky lines of business by the
commercial banks. Secondly, the deposits of he banks are of short-term nature and they may be withdrawn at any
time on demand or at short notice. Thirdly, mixed banking requires technical and entrepreneurial skill and Indians do
not posses it. Fourthly, the banks may be tempted to provide more and more short-term finance. Fifthly, interlocking
of banking funds has been an evil associated with Indian banking system for quite a long time. The bank’s funds may
be utilized by the same persons on the boards of the commercial banks. Finally, a German banking authority said that
Indian banks are weaker and it will be detrimental to the growth of both the banks as well as industries if these banks
were to participate in industrial financing.

Classification of Banks:

         A bank may carry on all kinds of work connected with lending and borrowing. But some banks specialized in
particular lines of business. On this basis banks may be classified as follows.

1) Commercial banks

        Commercial banks are financial institutions which will finance trade and industry with short term loans. They
also lend money to manufactures but only for short periods. Most of the Joint Stock banks in India, are commercial
banks, e.g. The Bank of India, the united Commercial bank the Punjab National Bank.

Exchange Banks

         Commercial banks which specialize in financing international trade (import and export trade) and dealing in
foreign money are known as exchange banks. The exchange banks operating in India are foreign owned with head
offices in foreign countries. The exchange banks provide foreign currencies to persons who are engaged in import
and export trade, e.g., The commercial Bank, The Lloyeds Banks, The Gridlays Bank etc.

Industrial and Investment Banks:

These are banks which borrow money for long periods and give long term loans to industries. The also organize and
undertake the sale of new issues of shares and debentures of companies. An industrial banks thus acts as a bridge
between capital savers and industrialists and therefore it has been called the entrepreneur of entrepreneur. E.g., The
Industrial Credit and Investment Corporation of India.

International Banks

         These banks are financial institutions specially created to deal with international financial relations (provision
of loans short and term to various countries). The most important international banks of to-day are the International
Monetary Fund, International Bank for Reconstruction and Development known as the World Bank and the
International Development Association.

Central Banks:

         A Central Bank is the Central Monetary authority in a country, usually issuing currency and controlling the
whole banking system. In almost every country to-day there is a Central bank. They are known by different name in
different countries, e.g. The Reserve Bank of India. The Fedral Reserve (U.S.A.), The Bank of England (U.K.), The
Bank of France (France).

Co-operative Banks:

        These are small banks organized on co-operative principles with a view to give short and medium term loans
mainly to agriculturists and artisans like Weavers and Spinners.

Land Mortgage Banks:

       These banks lend money on the security of land to the agriculturist for a long period, usually 20 or 25 years.
They secure funds by the sale of debentures usually with the government guarantee and assistance.

                                                     LESSON – 6

                                              PUBLIC SECTOR BANKS

Nationalised Commercial Banks

         The Government of India naitonalised fourteen major Indian scheduled banks in the private sector, having
deposits of Rs. 50 crores or over each, as on the last Friday of June 1969, with effect from July 19, 1969. The
aggregate deposits of these fourteen banks, at the end of 1958, amounted to Rs. 2,741.8 crores, nearly 72 per cent of
the total deposits of the Indian scheduled banks. Their advances amounting to Rs. 1743.6 crores were 65 per cent of
the total advances. These banks has a total paid-up capital of Rs. 28.5 crores which was about 1 per cent of their
aggregate resources. Their owned funds at the end of 1968 amounted to Rs. 66.0 crores and their aggregate net
profits amounted to Rs. 6.6 crores.

         The oldest of the major banks was Allahabad Bank (1865) and the youngest was United Bank of India (1950).
Since United Bank of India was set up by amalgamating foru existing banks it would not be proper to consider it as an
altogether new bank. This way, United Commercial Bank established in 1943 was the youngest of all these banks.
Allahabad Bank, before, its nationalization, was subsidiary of a foreign bank-Chartered Bank. All others were fully
Indian Banks mostly set up and dominated by big industrial houses. They were constituted as joint stock companies
with limited liability and, therefore, each of these bansk used ot add ‘The’ before its name and ‘Ltd’. after its name.
(For example, The Central Bank of India Ltd., The Bank of India Ltd., etc,). Form the point of view of the number of
offices opened by each of the major banks before nationalization, Punjab National Bank had the highest (544) and
Allahabad Bank the lowest number (128) as at the end of 1968. Actually, the position and the size of a bank are
judged on the basis of its deposits and advances. On this basis, Central Bank of India was the biggest followed by
Bank of India, Punjab National Bank, Bank of Baroda, United Commercial Bank, Canara Bank, United Bank of India,
Allahabad Bank, Syndicate Bank, Indian Overseas Bank, Indian Bank and Bank of Maharashtra. At the end of 1968,
Central Bank of India had aggregate deposits amounting to Rs. 433.27 crores. Bank of Maharashtra was the smallest
of these banks, having deposits of Rs. 73 crores.

        It is remarkable to not that even among the 14 banks, the bulk of the deposits and advances (about 63 per
cent) was controlled by the first five major banks. Of the total owned funds of Rs. 66 crores, the big five banks
accounted for abut 64 per cent, while their share in the aggregate net profit was about 70 per cent. Some large
business houses, who controlled these banks, claimed a lion’s share of the bank’s resources. By nationalizing the
major banks, the Government secured control over what Mrs. Indira Gandhi described as ‘the commanding heights of
the economy”.

          The most important reasons for nationalization of banks related to the structure, policies and working of the
private commercial banks. The banks had expanded their business and increased the number of their officers. There
was a five-fold increase in their deposits between 1951 and 1969. Over the years, the Indian banks were made sound
and viable through a system of licensing and inspection by the Reserve Bank and encouragement of mergers and
amalgamations. The Reserve Bank was given wide powers to regulate the functioning of banks. Practically, however,
banks were not serving he public interest and they had failed to provide credit for the desired priority channels.
Instead, they had become tools in the hands of monopolists and been encouraging speculative activity. The ‘social
control’ measures had failed to prevent misuse of bank credit. All these factors led to the take-over the major banks in
1969. The immediate causes responsible for nationalization of banks were political in nature, but there was adequate
justification for the action they purely on economic and social considerations.

        Smt. Indira Gandhi announcing the nationalization in a broadcast to the nation on July 19, 1969 said, “The
purpose of expanding bank credit to priority areas which have hitherto been somewhat neglected as also (i) the
removal of control by a few, (2) profusion of adequate credit for agriculture and small industry and exports, (3) the
giving of a professional bent of bank management, (4) the encouragement of new classes of entrepreneurs, and (5)
the provision of adequate training as well as reasonable terms of service for bank staff still remain and will call for
continuous effort over a long time. Nationalization is necessary for the speedy achievement of these objectives”.

        Six more banks, nationalized on April 15, 1980 were : Andhra Bank, Corporation Bank, New Bank of India,
Oriental Bank of Commerce, Punjab and Sind Bank and Vijaya Bank. These six banks has shown a phenomenal
growth in their operation during the past decade. The priority sector advance of the six banks constituted 30.9 per
cent of their total advances at the end of 1978. Their record in branch expansion was also quite impressive. It is
remarkable to note that the six banks had an average of 40 per cent of their branches in the rural areas. Among the
six banks, Punjab and Sind Bank in particular, exhibited the highest growth rate in branch-expansion, deposit-
mobilization and advances. Keeping their all-round progress in view, the question arises that why these six banks
were nationalized.

        The reasons given officially for nationalization were simple and straight forward and almost the same one as
in 1969. Better credit-planning and larger allocations to priority sectors were the guiding factors. The cut-off point this
time was placed at over Rs. 200 crores of deposits as on March 14, 1980 as against Rs. 50 crores in 1969.

        The Ordinance for the acquisition and transfer of the six banking companies says in the preamble that these
have been taken over “having regard to their size, resources coverage and organization, in order further to control the
heights of the economy, to meet progressively, and serve better, the needs of the developments of the economy and
to promote the welfare for the people, in conformity with the policy of the state towards securing the principles laid
down in Clauses (B) and (C) of Article 39 of the Construction.” The nationalization of six more banks in 1980 can thus
be considered as an extension of the measure of nationalization initiated in 1969.

          New Bank of India, one of the six banks nationalized in 1980, had been making losses during the past four
years. With the introduction of prudential accounting standards in April 1992, the imbalance in the financial position of
the New Bank of India came into sharper focus. In these circumstances, it became necessary in the interest of
depositors to merge it with a stronger bank. In September 1993, it was merged with the Punjab National Bank. This is
the first time that a nationalized bank has been merged.

Progress of Banking After 1969

It was intended to achieve the broad aims of bank nationalization through a two pronged approach: one, expanding
the banking network in all parts of the country with special emphasis on setting up adequate banking facilities in
hitherto unbanked or under-banked areas : and two, making bank credit available to all segments of the economy
and regions of the country. As it is obvious from the account given below, remarkable success has been achieved in
both these respects.

        1. Branch Expansion : A significant features of banking development after nationalization of major banks
has been the increasing tempo of branch expansion. Over the period of several decades in which modern banking
developed in India till June 1969, commercial banks had opened 8,262 offices. The number of offices of commercial
banks has increased to 48810 at the end of March 1996. As a result of branch expansion by banks, the national
average population per bank-office has declined from 65,000 at the time of nationalization in 1969 to 13,000 at the
end of June 1985 and 10,000 as at the end of March 1996.

         A rapid branch expansion was witnessed in the seventies and the eighties. In recent years, however, there
has been considerable emphasis on the consolidation of the banking system. Towards that end the branch Licensing
Policy for the period April 1985 to March 1990 (extended up to March 1993) was formulated keeping in view he need
for banks to concentrate on consolidation of their position and achieving a coverage of 17,000 population (1981
census) per bank office in rural and semi-urban areas of each block and providing banking facilities in those pockets
of rural areas where wide spatial gaps existed. With the adoption of the Service Area Approach in 1989, it had
become necessary to allow opening of additional branches in rural areas so that the number of villages allocated to
the rural branch was within a manageable limit of 15 to 25 villages per bank branch. In other areas, opening of
branches is allowed purely on viability criteria.

“Approach to Future Branch Expansion” circulated by the RBI in Sept. 1990 prescribed that the phase of consolidation
was to continue with emphasis on all-out effort to improve operational efficiency , quality of assets and financial
strength of banks and the growth of bank offices will depend on well-established need, business potential and
financial viability of the proposed offices.
Under the 1985-90 branch licensing policy, 5,360 rural/semi-urban centres were allotted to banks in addition to 1,454
rural centers allotted under the Service Area Approach and 635 centres in urban/metropolitan/port town centres. Out
of 7,449 centres allotted as above banks were able to open offices at 6,912 centres up to end June 1992 with the
expiry of the extended validity period on March 31, 1993, all the pending licences were cancelled.

         The main thrust of the branch licensing policy for 1990-95 continues to be on providing freedom to banks to
rationalize the structure of their branches. Accordingly, the distance stipulation of 400 meters between two branches
of banks in towns have been withdrawn. Banks have been allowed to open one specialized branch per centre each in
the category of industrial finance, NRI and Treasury branches without the prior approval of the Reserve Bank. They
can also convert their non-viable rural branches into Satellite Offices on certain conditions and provide locker facilities

in extension counters. Banks have also been allowed to close, on mutual consultation, one loss making branch at
rural centres served by two commercial bank branches excluding RRBs.

        2. Dispersal of Bank offices : Two aspects need to be underlined in this context : first, the thrust of
expansion was primarily in unbankede areas; secondly, branch expansion was planned in such a manner as to
reduce regional disparities in banking development.

         Of the 52,986 opened between July 1969 and June 1993, about 66 per cent offices were opened in unbanked
centres. Since a large number of unbanked centres was in rural areas, the pace of branch expansion in recent years
has mace considerable progress in penetration into the rural areas. The proportion of bank-offices in rural areas to
the total was 22.1 per cent at the end of June 1969. This proporation increased to 57.8 per cent at the end of June
1993. The policy aim of achieving coverage of one branch for every 17,000 persons in rural and semi urban areas
has been largely achieved.

         The regional disparities in the distribution of bank offices have also declined substantially after 1969. The
under-banked States and Union Territories have received special attention in banking development. Regional
disparities in respect of distribution of bank offices still continue, the southern region accounts for the largest share,
while the north-eastern and eastern regions are lagging far behind other regions. But the disparities are less
pronounced now.

        3. Overseas Expansion : At the end of 1968, there were 59 offices of seven Indian Banks in 14 foreign
(excluding 17 offices in Pakistan and 22 in Bangladesh which have been taken over by the Custodian of Enemy
Property, Pakistan). After nationalization of banks in 1969, 19 foreign offices had to be closed between 1969 and
1973 mainly because the laws of certain countries did not permit the functioning of any State-owned or foreign bank.
However, the years subsequent to 1973 witnessed a marked acceleration in the field of overseas branch expansion.
At the end of March 1996 there were 124 branches of 9 Indian banks.

         Foreign offices of Indian banks provide the necessary infrastructure for the collection and transmission of the
remittances from abroad. In addition to their traditional business, covering activities supplemental to the country’s
trade and assisting expartriate Indians, they have started to play a major role in helping Indian joint ventures abroad
in the form of extension of credit, providing information on the country, helping arrangements for equity participation
and serving of the necessary capital movements. Representative offices, which have no operational responsibility,
play an important role in exploring and promoting business opportunities and provide supporting services for other

        4. Mobilization of Resources : The commercial banks have made concerted efforts at deposit mobilization
through a series of measures and schemes. The aggregate deposits of scheduled commercial banks had increased
from Rs. 881 crores at the end of March 1951 to Rd. 4,646 crores at the end of June 1969. The deposits increased
very rapidly after nationalization of major banks. Aggregate deposits of scheduled commercial banks at the end of
March 1996 stood at Rs. 457639 crores.

        All all-round increase in bank deposits has been largely due to rising money supply in the economy. However,
the expansion of bank offices and the attempts at deposit mobilization by banks have also greatly helped in raising
the volume of resources available to banks in the form the public. It is true that the high rate of inflation in the post-
nationalization years would cot the growth rate in deposits by more than half, but a real average annual growth rate of
8 or 9 per cent is still very impressive.

         5. Credit Expansion : The credit policy of banks, as directed by the Reserve Bank, was directed towards
promoting investment, aiding production and exports, and assisting the priority sectors and weaker sections of the

          Bank credit (loans and advances together with bills purchased and discounted) of scheduled commercial
bansk increased from Rs 3,599 crores to Rs. 252400 crores between June 1969 and March 1996. Between 1969 and
1980 the average annual rate of increase in bank credit was around 18 per cent, as against 10.6 per cent between
1951 and 1969. Between 1980-91 and 1989-90 the average annual rate of increase was 16.8 per cent. On an
average basis, expansion in bank credit in 1993-94 at Rs. 12,436 crores (8.2 per cent) was much smaller than an
increase of 21.0 per cent in 1992-93. In recent years there was a decline in advances made for food procurements,
i.e., food credit. The growth rate of non-food credit in 1993-94 (5.7 per cent) was also substantially lower than that in
1992-93 (20.1 per cent). This is largely due to the fact that corporate entities have started rising large amount of funds
from the capital market and banks have restricted credit in the context of prudential norms.
       Investment in Government securities by scheduled commercial banks increased from Rs.1,055 crores in
March 1969 to Rs. 16,776 crores in March 1985 and Rs. 1281128 crores in March 1996. This was in addition to
investments in other approved securities.

         6. Lending to Priority Sectors and Weaker Sections of the Society : Apart from financing public food
procurement and exports, commercial banks, both in the private sector and the public sector, have extended liberal
credit facilities to the priority and neglected sectors of the economy which include agriculture, small-scale industries
and other priority sectors comprising small businessmen, professional and self-employed persons and persons
desirous of receiving higher education.

         A scheme of differential interest rates (DRI) by public sector banks on advances made to the weaker sections
of the community was announced by the Government in March 1972. The Reserve Bank laid down the criteria for
identifying persons who will be eligible for concessional loans under the scheme and the condition under which loans
should be given. Since November 1978, the private sector banks have been put under the same obligations as the
public sector banks in the deployment of their funds. The banks have been asked to lend one per cent of total
advances under the DRI scheme, 40 per cent of such lending being to Scheduled Castes and Tribes. Public sector
banks as a group exceeded the target in 1980.

        7. Rural Lending : Service Area Approach: The realization of Indian Commercial banking has meandered
through many policy prescriptions. Rural branches of commercial banks constitute about 58 per cent of total
branches. Commercial banks and Regional Rural Banks (RRBS), sponsored by the scheduled commercial banks,
provide multi-purpose and multi-term credit for agriculture and allied activities. As a result, both farmers and non-
farmers in the rural sector have comparatively an easy access to the lending windows of the commercial banks.

        Public sector banks were direct to attain by March 1979 a credit deposit ratio of 60 per cent in rural and semi-
urban areas separately. The stipulation was later extended to private sector banks also. Scheduled commercial banks
as a whole have succeeded in attaining the target in respect of rural branches. They have, however, fallen short of
the target in case of semi-urban branches.

        Service Area Approach to rural lending which is operative since April 1, 1989 ahs envisaged that each rural
and semi-urban branch of commercial banks would be assigned a specific area comprising a cluster of village within
which they will operate, adopting a planned approach for its economic growth and thus avoiding duplication of efforts
and scattered lending over wide areas. Within the cluster of allotted villages, only one branch will operate, thereby
avoiding multiple financing and scattered lending and ensuring greater credit discipline.

        Service Area Approach aims at improving the credit delivery system and making bank branches effective
instruments of rural development. Each Branch Manager is expected to make a detained survey of the villages
included in his service area, study the development potential and credit needs under various activities in the context
of availability of market and infrastructure facilities and development programmes for the area and prepare his
programme for banking on the basis of such a study. The annual credit plans are prepared by bank branches. Credit
planning in banks would thus start from the grass-roots and be aligned with the programmes of development
agencies. This approach establishes direct responsibility of the branches for ensuring the extension of better and
more purposive credit facilities to the rural people so that an optimum alignment among agricultural credit,
productivity, production and recycling of foods is established.

         8. Expanding Credit to Export Sector : The export sector has all along received high priority in the provision
of bank credit. As a result, the export credit outstanding at the end of March 1994 amounted to Rs. 17,094 crores
which was 11.2 per cent of total net bank credit against the stipulated target of 10 per cent to be reached by end-June
1993. Under directions from Reserve Bank Several measures have been introduced to ensure the availability of
adequate and timely credit to the export sector. The terms of various export credit schemes have been liberalized
from time to time. In order to provide credit to Indian exporters at international competitive rates of interest, it has
been decided in October 1993 that Pre-shipment Credit in Foreign Currencies (PCFC) which is available for export
related imports since November 1991, would be available in major convertible currencies to exporters at LIBOR-
related rates of interest for financing of domestic inputs, also of goods exported. Banks in India could also arrange for
lines of credit from abroad for the purposes of extending PCFC and rediscounting of export bills abroad.

       9. Lead Bank Scheme: The Lead Bank Scheme (LBS) was introduced by the Reserve Bank in December
1969 on the basis of the recommendation of a study group appointed by the National Credit Council under the
chairmanship of the late Prof. D.R. Gadgil. The basic objectives was one of orienting banking development in the
country towards an “area approach” and thus ensuring that the developmental needs of all regions and all sections of
the community are served by the banking system in conformity with the national priorities. The administrative unit
‘district’ was taken as the nucleus of this approach and all the districts in the country were initially allotted among the
State Bank Group, 14 nationalised banks, and three private banks. Each bank was expected to survey the potential
for banking develpent in the allotted districts, to identify institutional and credit gaps and to take the initiative in
endeavouring to fill them and thus intensively involve itself in the process of economic advancement of the districts
concerned. The Lead Bank does not have a monopoly over banking business in the districts allotted to it. However, it
acts as the leader of all the other ansk in those districts, works closely with them and the other financial institutions in
the area and the Governement Departments, and jointly sponsors the banking development of those districts so as to
help in their overall economic development. The Lead Banks prepare district credit plans, but non-lead banks have as
much responsibility as the Lead Banks in promoting development efforts in the districts concerned. Lead Banks
undertake the formulation of District Credit Plans for their lead districts and also Annual Action Plans before the
commencement of each year. The credit plan is a comprehensive plan indicating credit targets for institutional credit
agencie4s in the district on a block-wise, sector-wise, scheme wise and bank-wise basis. The Lead Bank Scheme has
been operating in 483 districts of the country at the end of March 1994.

         10. Innovations and Diversification of Business : Commercial banks have been encouraged to diversify
into fresh areas of business, viz., merchant banking, equipment leasing, venture capital, mutual funds, housing
finance and other financial services. They have introduced innovative schemes of deposit mobilization, providing
consumer credit, issuing credit cards etc. Several banks have set up separate subsidiaries for the purpose. Two
banks have set up subsidiaries to commence factoring services.

         The Government security market in India has traditionally been narrow and captive with low coupon rates,
distributional investors such as banks and other institutions dominate the market to meet their statutory requirements.
These/bansk institutions have invested huge sums of money. However, there is no active secondary market in
securities. The raising of coupon rates on Government securities, freeing of inter-bank call/notice market from ceilings
on interest rates, introduction of new instruments (like 182 days Treasury Bills, inter-bank participations, Commercial
Paper, Certificated of deposits, etc.) where the rates of interest are not administered gbu determined by market forces
and such other liberalizations have been much helpful to commercial banks. To encourae bill culture, steps like
lowering of bill discounting rates, stipulation of norms for use of bills for credit purchases and credit dales etc. have
been taken. Prudential norms of lending have been laid down for banks so as to reduce the risks for individual banks
and enable them to grow in healthy lines.

       Over the years, banks have been growing into broad-based financial service institutions. The innovations          of
Commercial banks indicate their adaptive skills and the vital role they have been playing in the process                 of
development, spanning rural and urban, agricultural and non-agricultural and organized and unorganized sectors           of
the economy-each sector needing different approaches, skills and techniques. Here lies the real achievement              of
Commercial banks in India.

                                                       LESSON – 7

                                          INDIAN PRIVATE SECTOR BANKS

         Ever since the nationalization of the 14 major commercial banks on 19 July 1969, the entire thrust of the
banking policy had been to project the image of public sector banks. The Policy documents, speeches by the
authorities, articles, write-ups etc. in fact, the whole trend of thinking consciously or unconsciously, was concentrated
on highlighting the role of public sector banks in economic development. Prodigious promotional literature was
published projecting the yeoman services rendered by public sector banks to bring about social transformation
through economic development. It needs to be stressed that the objective of “mass banking” had to be thrust on the
nationalized banks. The private sector banks have been fulfilling this objectives right from their inception, since they
are “at home” with the sons of the soil. Much of the service rendered by them, however, went unnoticed. In the
process, great damage was unwittingly done to the innocent private sector banks.

         It is indifference to the very existence of the Indian private sector banks that led to policy discrimination in the
Agricultural and Rural Debt Relief Scheme of 1990. The scheme was made applicable to public sector banks and
cooperative banks but not to the private sector banks. What is intriguing and even irritating is the fact that despite
repeated requests by the private sector banks to make the scheme available to their borrowers, this request went
unheard. Under such circumstance of utter neglect, it is surprising that these private sector banks continue to survive
and even thrive. They draw their inspiration loyalty and devoted service of their staff. It is an acknowledged fact that of
the different groups of banks, customer service is the best in the Indian Private Sector banks.


        The gloomy and sullen climate which the Indian private sector banks suffered silently for more then two
decades has changed for the better. Two important recommendations of the Narasimham Committee which bring a
refreshing air for the Indian private sector banks are:

    (i)     The Government should indicate that there shall be no further nationalization of banks and
    (ii)    There should not be any difference in treatment between public sector and private sector banks.

    In response to the firs point the then Prime Minister while at Devos in Switzerland declared that there will be no
    further nationalization. As regards the second, the industry ministry has issued a circular to al Central public
    sector undertaking which states that they can, unlike in the past select any bank, private, public or foreign of their
    choice for purposes of their transactions. Thee developments have opened up new vistas for the growth and
    expansion of private sector banks on a massive scale.

        It must, however, be recognized that the mere issuance of a circular will no ensure availability of business of
    the public sector undertaking to the Indian private sector banks. Apart from the central public sector undertakings,
    there are a number of state public sector undertakings and departments of central and state governments as well
    as local governments which are not covered by the circular of the Ministry of Industry. Unless the State
    Governments and the local Governments also fall in line the discrimination between public and private sector
    banks will continue. More importantly, the private sector banks, handicapped as they were for more than two
    decades, have if the doors of the cages are thrown open to-day, they are unable to fly forcefully in the open.
    Nevertheless, an atmosphere of freedom and no discrimination will eventually strengthen these banks to go in for
    aggressive banking.

       At present we have 30 private sector banks comprising of old private banks and 7 new banks set up in
    1990s. All these banks are well placed in terms of productivity and profitability.


         The Indian Private Sector Banks posted excellent operational results for the year ended March 1995. Capital
and Reserves over the previous year increased by 61 per cent and 79 per cent respectively. Deposits grew by 31 per
cent, investments by 32 percent, advances by 42 percent and total assets by 41 per cent. Income growth during the
year at 35 per cent was quite impressive compared to 26 percent in the previous year. Greater control in expenditure
was evident with its growth of 27 percent during the year, slightly higher to that of 23 per cent reported in the previous

         Increase in business, enhanced thrust in income, focus on curtailing expenditure resulted in the net profits of
this group on Indian Private Sector Banks jumping by an impressive two fold during the year. These banks have been
able to show noticeable rise in profitability and productivity, through there is no perceptible change in the spread.

        Indian Private Sector Banks have been alert in reaping the benefits of the liberalization and deregulation of
the banking sector.

        Table 1 Highlights the Suring Profitability of Private Sector Banks.

                                                        Table 1

                                                 Surging Profitability

                                          Net Profit as % of Working Funds

                                           1992-93                   1993-94                  1994-95
          Vysya                              0.67                      0.76                     1.64
          Federal                            0.42                      0.66                     1.30
          J&K                                0.20                      0.53                     0.58
          Rajasthan                          0.41                      0.84                     2.04
          South Indian                       0.22                      0.77                     0.85
          United Western                     0.18                      0.32                     0.63
          Karur Vysya                        0.82                      1.16                     1.53
          Karnataka                          0.67                      0.65                     0.80
          Madura                             0.53                      0.30                     2.08
          Catholic Syrain                    0.27                      0.42                     0.35
          TN Mercantile                      0.99                      1.12                     1.35
          Lakshmi vilas                      0.67                      0.65                     1.56
          Sangli                             0.12                      0.26                     0.18
          Bharat Overseas                    0.12                      0.64                     0.79
          Dhanalakshmi                       0.21                      0.42                     0.84
          City Union                         0.62                      0.56                     1.07
          Benaras-State                      -4.64                    -3.45                    -1.87
          Nedungadi                          0.04                      0.06                     0.29
          Lord Krishna                       1.73                      0.98                     1.42
          Bareilly Corp.                     0.04                     -0.64                    -0.22
          Nainital                           0.50                      0.15                     0.25
          Ratnakar                           0.03                      0.59                     0.56
          Punjab co-op                       -2.99                    -3.07                    -0.59
          Total                              0.34                      0.57                     1.16

Performance of the Indian Private Sector Banks for the year ended March 1995 in Key areas of business is
highlighted below:

       Capital of the Indian Private Sector Banks during the year increased from Rs. 121 crores to 194 crores.
Reserves moved up form Rs. 545 crores to Rs. 976 crores. Capital and reserves together jumped by 76 per cent from
Rs. 666 crores in March 1994 to Rs. 1170 crores in March 1995. Benaras State Bank showed massive infusion of
capital from Rs. 15 crores to Rs. 61 crores during the year where as it showed as marginal decline in the reserves. As
many as seven banks more than doubled their reserves during the year.

         For the second successive year, private sector banks have been able to report deposit growth of over 30 per
cent – 30.5% in 1993-94 and 31.4% in 1994-95. Total deposits increased from Rs. 20069 crores in March 1994 to Rs.
26395 crores in March 1995. Eleven banks managed to cross the group average with growth rates ranging from 32
per cent to 83 per cent. One Bank in the scheduled category and one in the non-scheduled category reported growth
rates of less than 10 per cent. The growth in advances was quite robust from Rs. 9798 crores in March 1994 to Rs.
13957 crores in March 1995. Bill purchased by 33 per cent, cash credits/overdrafts by 46 per cent and term loans by
41 per cent. Eleven banks crossed the group average of advances growth (42%) ranging from 43 per cent to 107 per
cent. Investments reported a healthy growth 32 per cent. Investments in Governments Securities increased by 24
percent, in other approved securities by 7 per cent, in shares by 375 per cent and in debentures and bonds by 98 per

        The income of the Indian Private Sector moved up from Rs. 2372 crores during the year 1993-94 to 3211
crores during the year 1994-95. Interest and Discount rose by 32 percent, income on investments by 41 percent and
other income by 41 percent and other income by 46 percent. Under the other income, sale of investments reported
highest jump of 69 percent, followed by commission/exchange/brokerage which grew by 38 percent. The expenditure
of these banks rose from Rs. 2259 crores to Rs. 2863 crores. Interest expenditure showed a rise of 31 percent and
operating expenses by 28 per cent. The net profit of the Indian Private Sector Banks showed a significant rise from
Rs. 112 crores in 1993-94 to Rs. 347 crores in 1994-95.

        All the key operational performance indicators showed a surge. Profit as a percentage of working funds rose
from 0.49 percent in 1993-94 to 1.12 percent in 1994-95. Non-interest income as percentage to total income from
12.79 per cent to 13.80 per cent, Deposit Per Employee from Rs. 37 lakhs to Rs. 48 lakhs, Advances Per Employees
from Rs. 18 lakhs to Rs. 25 lakhs. Establishment Expenses as percentage to total expenditure remained same as of
the previous year at around 17 percent.


         Private Sector banks presently operating in Indian are inherently strong and this could be seen from the fact
that they had a smooth transition from the pre-reform period to the post-reform phase. Some of the banks covered in
the profiles section achieved capital adequacy norm in 1993 itself. The level of non-performing assets is quite low for
many of them, in fact, it is less than 5 per cent for some of them. Generally, they have been able to post good results.
Conservative management styles prevalent in these banks have ensured adherence to prudential norms-reform or no
reform. In other words, they were subjected to market discipline even before the process of reform was initiated.

        Profitability of many of the private sector banks has been quite good. Dividend payment to shareholders has
been a regular feature and the rates of dividend have been going up over the years. Shareholders are also rewarded
with bonus shares and right issues periodically. The need for augmenting the capital base as a result of financial
sector reforms, has made private sector banks to seek these avenues quite frequently in the recent past. The private
sector banks have also come out with public issues which have received good response from the investors indicating
their confidence in these banks and their growth prospects. The shares of private sector banks are quoted in may
stock exchanges at substantial premium.

         The good track record of the private sector banks can also be a cause of anxiety for the managements of
private sector banks in the liberalized environment as it tempts outsiders to make takeover attempts. Since, many of
these banks are closely held by certain communities, attempts. Since, many of these banks are closely held by
certain communities, attempts by outsiders to takeover has been resisted. While, some managements feel that
takeover bids by themselves are not bad provided the institution is benefited, others want to safeguard the interests of
the existing shareholders. One method which has been used by some banks is to invite institutions to participate in
the equity contribution of ICICI in Federal Bank is proposed to be used by the management for business expansion.
ICICI may be expected to participate in the management of the bank by having its nominee on the board. Business
synergies between the two institutions may also be worked out, according to Shri M.P.K., Nair, Chairman & Chief
Executive Officer of the Federal Bank Ltd. On the question of increasing competition in the deregulated environment,
Shri Nair welcomes the entry of new private sector banks and feels that this will benefit the customers ultimately.

       Another bank which has ICICI and other institutions participating in its capital is The South Indian Bank Ltd.
Shri Cherian Varghese, Chairman & Chief Executive Officer, South Indian Bank Ltd. excudes confidence about the
future of the private sector bank in India. They are set to grow faster in the coming years. He is also receptive to the
process of liberalization unfolding in the Indian economy and banking, but, if of the new that it should go hand in hand
with control and supervision of banks by the RBI.

         As for the future, the private sector banks can look forward to a period of high growth accompanied by greater
profitability. The industry report on Indian Banking prepared by Jardine Fleming Indian Broking Limited affirms this.
The report which covered 15 private sector banks finds that these banks have handled their bad debts quite well on
account of consistent monitoring of loan portfolio. Better customer service also ensures quality of assets. The private
sector banks, are poised to show higher profitability in coming years. They have also come out on top on studies
other than Jardine Fleming mentioned above, the notable example being the CRISIL study, the results of which are
quoted by some banks in their annual reports.

                                                     LESSON – 8

                                         CENTRAL BANKING – EVOLUTION

Central banking is of recent origin. Prior to the commencement of the twentieth century, there had been no clearly
defined concept of central banking. But today there is no country in the world which does not have a central bank. It is
the bank that acts as the leader of the money market. It supervises, regulates and controls the functions of
commercial banks and other financial institutions. It acts as the banker to the government. It plays an active role in
implementing government’s economic policy in the country. According to Walls Roger, central bank occupies the
coveted position of being one fo the three great inventions that have taken place since the beginning of times, the
other two being the fire and the wheel. Although some people may seriously doubt if central bank could belong to
such an exalted company, but they all agree that the central bank is one of the most useful economic institutions
which has been developed to help society to manage its collective financial affairs. Today, central bank is the central
arch of the monetary and fiscal framework in every country of the world and its activities are essential for the proper
functioning of the economy and indispensable for the fiscal operations of the government.

Central banking – Evolution

         Although some central banks established more than two centuries ago, central banking is mostly a recent
development being essentially a product of the nineteenth century. The earlier institutions were by and large, banks of
issue with the sole of principal right of note issue. Modern central banking techniques were unknown to them. They
were not much different from other existing institutions doing banking business except for the special relations which
they had with their respective governments. It was only through process of trial and error did they come to occupy a
pivotal and strategic status which they enjoy in the present day monetary and banking structure.

         The oldest central bank in the world is the Riks Banks of Sweden. It was established in 1956. The Bank of
England come into being in 1694. However it was the first bank to assume the position of a central bank and to
develop what are not generally recognized as the fundamentals of the art of central banking. The history of the Bank
of Englanc is universally accepted as the history of the evolution of central banking principles and techniques. The
successful working of the Bank of England stimulated the development of central banking in other parts of the world.
The Bank of France which was organized in 1800 was closely connected with the state ever since its establishment.
The Reiches bank in Germany was established in 1876. The Bank of Netherlands was founded in 1814 on the ruins
of the old Bank of Amsterdam. The National Bank of Austria, which was reorganized as the Bank of Austria-Hungary
in 1877 was established in 1817 to restore order in the national monetary system which had deteriorated due to over
issue of paper currency. The Bank of Norway, the National Bank of Denmark, the National Bank of Belgium and the
Bank of Spain were established in 1860 to consolidate money circulation and to float debt for the Russian Empire.
The Bank of Japan was set up on 1882 to restore order in the currency system of the country. The Bank of Italy was
established in Portugal, Rumania, Bulgaria, Servia, Turkey, Java, Egypt and Algeria. These banks possessed the
monopoly the monopoly of note issue. Thus nineteenth century was a century par excellence of the establishment of
central banks in many countries of the world, particularly in Europe, where almost every country had established a
central bank empowered to issue notes with special privileges and powers. In due course of time, these banks
became bankers and advisers and advisers to their respective governments.

Although by the end of the nineteenth century almost every country in Europe had a central bank, the concept of
central bank was not, of course, too clearly articulated or understood before the turn of the century and some of these
banks were not fully aware of their special functions and responsibilities. For example, the Swedish Riksbank and the
Bank of Italy probably did not become “real” central banks until about the turn of the century. Moreover, the countries
in other continents of the globe, barring a few, also did not have central banks. In fact, in 1900, there no central bank
in the Western hemisphere. The Federal Reserve System in the U.S.A. was established in 1913, while the Bank of
Canada was established in 1934. Important countries of East such as India and China had no central banks.

         Thus, in the twentieth century, the work of establishing the central banks continued. The First World War and
the consequent chaotic monetary conditions brought home to those countries without a central bank the imperative
necessity of establishing a centralized institution capable of creating and maintaining equilibrium in the monetary
sphere. The great encouragement of the development of central banking was provided at the International Financial
Conference held in Brussels in 1920. This conference resolved that “all those countries which had not yet established
a central bank should proceed to do so as soon as possible, not only with a view to facilitating the restoration and
maintenance of stability in their monetary and banking systems but also in the interest of world Cooperation”. The
Genoa Conference, in the spring of 1922 also emphasized the importance of a central bank as an agency to correct
the financial disequilibrium and to promote international cooperation in the monetary world.
        There was a welcome receiption to these advices throughout the world. The next three decades saw many
countries equipping themselves with central banks. From 1921 to 1937, barring 1929 and 1930, every year one or
more bank was added to the list of central banks. Just as the Brussels conference of 1920 accelerated the pace of
growth of the central banks after World War I, in the same way the IMF further facilitated the development of central
banks in the new Afro Asian and Latin American countries. The governments of these countries found that the central
bank could deal more effectively with the IMF and other related matters relating to foreign exchange.

         The importance of central banking institutions has thus gained universal recognition and now they occupy a
unique position in the economic map of every civilized country. It took nearly three centuries for the art of central
banking to attain the present day importance. Nevertheless, it would not be correct to say that central banking has
attained its full growth. Indications are that the role of central banks is continually expanding. In words of De Kock,
“central banks have developed their own code of rules and practices, which can be described as the art of central
banking but which in a changing world, is still in the process of evolution and subject to periodical readjustment.

         The central banks were originally started as privately owned joint stock banks. They were managed by the
share holders. The structure and organization of the central banks were closely connected with the economic
conditions which prevailed at the time of their establishment. They were privately owned because their object was to
provide finance to the government. Even then most of the central banks were subject to a certain degree of control by
their governments. Gradually the trend towards nationalization of central banks gathered momentum. Central banks
have now become important organs of the governments. They changes in the economic conditions of each country
raised the status of central banks to the position of the leader of the entire banking system in the respective countries.

What is a Central Bank?

        A modern central bank performs so many functions of different nature that it is very difficult to give any brief
but accurate definition of a central bank. Any definition of a central bank is derived from its functions and these
functions have varied from time to time and from country to country. In other words, the functions of central banks
have grown over time making it more difficult to give any brief and unchanging definition of a central bank. We may
say that a central bank is one which acts as the banker to the governments and the commercial banks, has the
monopoly of note issue, operates the currency and credit system of the country and does not perform the ordinary
commercial banking function.

         Economists have defined central bank differently, emphasizing its one function or the other. According to
Vera Smith, “the primary definition of Central banking is a banking system in which a single bank has either complete
or a residuary monopoly of note issue”. In the statutes of the Bank for International Settlements, a central bank is the
bank in any country to which has been entrusted the duty of regulating the volume of currency and credit in the
country”. The fact that several banks have been named reserve banks, appears to show that in the opinion of some
authorities the custody of bank reserves is the characteristic function of a central bank.

         M.H. Dekock’s definition of a central bank appears to be better than many of the other definitions. In his
definition, he includes all the important functions of the central bank. However, his definition lacks brevity which is an
essential quality of any definition. According to Dekock, a central bank is a bank which constitutes the apex of the
monetary and banking structure of its country and which performs, as best as it can in the national economic interest,
the following functions.:

        (a) The regulation of currency in accordance with the requirements of business and the general public, for
            which purpose it is granted either the sole right of note issue or at least a partial monopoly thereof.
        (b) The performance of general banking and agency services for the Government.
        (c) The custody of the cash reserves of the commercial banks.
        (d) The custody and the management of the nation’s reserves of international currencies.
        (e) The provision of credit facilities in the form of rediscounts or collateral advances, to commercial banks,
            discount houses, bill brokers and dealers or other banking institutions, in its capacity as the bankers’ bank
            and the general acceptance of the responsibility of lender of last resort.
        (f) The settlement of clearance balances between the banks and the provision of facilities for the transfer of
            funds between all important centres.
        (g) The control of credit in accordance with the needs of business and the economy generally and for the
            purpose of carrying out the broad monetary policy adopted by the Government.

While the older central banks performed the functions enumerated above mostly as the result of tradition, the newer
central banks and some of those functions specifically entrusted to them by statute. Preambles stipulating particular
objectives of monetary policy were also introduce in the thirties. For example, in the preamble to the Bank of Canada
Act, that bank was directed “to regulate credit and currency, to control and protect the external value of the national
monetary unit and to mitigate by its influence fluctuations in the general level of production, trade prices and
employment so far as may be possible with in the scope of monetary action”, the preamble to the Reserve Bank of
India Act referred to that bank as being constituted to “regulate the issue of bank notes and the keeping of reserves
with a view to securing monetary stability in India, and generally to operate the currency and credit system of the
country to its advantage”.

         Moreover, the statutes of many of the newer central banks circumscribe their powers and functions to such an
extent that those statutes amount almost to a definition of what a central bank should or should not do. The noticeable
trend in central banking legislation towards a more or less standard type, after allowing for the political constitution
and the stage of economic development of different countries, affords a practical illustration of the existence of a
clearly defined concept of central banking.

                                                      LESSON – 9

                                         FUNCTIONS OF A CENTRAL BANK

According to De Kock, a central bank should perform the following seven functions. These seven functions are
contained in his famous work “Central Banking”.

1. Bank of Issue

        The most important functions of a central bank is that it acts as the bank of issue. It is charged with the
responsibility of issuing notes. The privilege of the note issue is the monopoly of the central bank. No other banks
have the right to print and issue currency notes. In the opinion of De Kock. “ The privilege of note issue was almost
everywhere associated with the origin and development of central banks.” The central banks take into consideration
three important views in the issue of notes-uniformity, elasticity and security.

          The concentration of note-issue in only one bank (central bank) has many advantages. Firstly, it brings about
uniformity in the note-issue. Secondly, the uniformity in the note-issue facilitates trade and commerce within the
country. Thirdly, the system of note-issue by only one bank attaches distinctive prestige to the currency notes.
Fourthly, this system enables the central bank to influence and control credit operations of the commercial banks.
Fifthly, this system avoids the over-issue or under-issue of currency notes. Sixthly, the Governments can appropriate
partly or fully the profits of note-issue. Finally, there is a good amount of security to the note-issue as there is a very
close and cordial relationship between the central bank and the government.

2. Banker, Agent and Advisor to the Government

         The central bank everywhere acts as the banker, fiscal agent and adviser on all important financial matters to
the government. In the first place, it conducts the banking accounts of government departments and enterprises. It
advances short-term loans to government. Thus it performs certain banking functions to the government. In the
second place, the central bank performs certain functions for, and on behalf, on the government. It makes and
receives on behalf of the governments certain payments. It is the agency through which government loans are
floated. It pays interest on the national debt. It carries out all the arrangements concerning redemption of public debt.
Thus the central bank acts as the agent of the government. In the third place, it also acts as the adviser to the
government in all financial and economic matters. It advises the government to follow a suitable monetary policy in
times of booms and depressions. It advises the government in the matters of public borrowing. It prescribes methods
for redemption of national debt. Thus the central bank is a banker, financial agent and adviser to the government.

3. Bankers’ Bank

        The central bank acts as the bankers’ bank. As bankers’ bank it performs several functions. Firstly, the
commercial banks of the country are required, either by law or by custom, to keep a certain portion of the deposits
they receive from the public. Thus portion of deposits kept with the central bank is known as the cash reserves of the
commercial banks. They can draw currency from the central bank during busy seasons and pay in surplus currency
during slack seasons. Thus the central bank acts as the custodian of the cash reserves fo the commercial banks.
Secondly, the central bank rediscounts bills of commercial banks. Thirdly, the central bank provides good and ample
leadership to the commercial bank. It gives directions to the commercial banks during periods of grave concern. In its
notes to individual banks, it may point out their failings and exhort them to fall in line with its policy. The commercial
banks always look to the central bank for guidance and directions. Fourthly, effects centralization of the cash reserves
of the commercial banks in the community. When these reserves are pooled together by the central bank, it employs
these reserves to the fullest extent possible and in most effective manner during periods of seasonal strain, financial
crises and general emergencies. By performing these various functions, the central bank acts as the bankers bank.

4. Custodian of the Foreign Currency Reserves of the Country

        The central bank also acts as the custodian of the foreign currency reserves of the country concerned. Under
gold standard, the central banks were required by law to maintain gold reserves against note-issue. And now, after
the abandonment of gold,. Standard, the central banks are supposed to keep both gold as well as foreign currency as
reserves against note-issue. This most important function is entrusted to the central bank for three obvious reasons-to
correct any disequilibrium in the balance of payments position of the country, to maintain the rate of exchange and to
manage exchanger control.

5. Lender of the Last Resort

         The central bank also acts as the ultimate lender of the last resort. By lender of the last resort, the central
bank of the country assumes the responsibility of meeting directly or indirectly all reasonable demands for financial
accommodation from the commercial banks, discount houses and certain other credit institutions. Today this
important function has come to be regarded as the sine qua non of central banking. By rediscounting first class bills,
or by taking advances on approved short-term securities from the central bank, other banks can increase their cash
resources at the shortest possible notice. Whenever crisis or a panic develops into a run on banks, this facility by
turning their good assets into cash at a moment’s notice is a great advantage to them. Thus the central bank is the
ultimate source from which the commercial banks can get emergency credit to meet the demand for cash on the part
of the panic-stricken people.

6. Central Clearance, Settlement and Transfer

         As banker’s bank, the central bank keeps the cash balances of all commercial banks. It is easier for member-
banks to adjust their claims against each other in the books of the central bank. For example, if Bank A has a cheque
for Rs. 1,000 on Bank B which has a cheque for Rs.1,500 on Bank A, the easiest way to clear and settle the two claim
is for Bank A to give a cheque to Bank B for an amount of Rs. 500 on the central bank of the country. As a result of
this transfer, Bank A’s account will be debited by Rs. 500, while Bank B’s account will be credited by Rs. 500. There
is thus no necessity for money to come into the picture at all. Apart from economy in the use of money, much of
labour and inconvenience, associated with the individual system of clearance and settlement, is removed.

7. Controller of Credit

         Probably the most important of al the functions performed by a central bank are that of controlling the credit
operations of commercial banks. In modern times, bank credit has become the most important source of money in the
country, relegating coins and currency notes to a minor position. Moreover, it is possible, as we have pointed out in a
previous chapter, for commercial banks to expand credit and thus intensify inflationary pressure or contract credit and
thus contribute to a deflationary situation. It is, thus, of great importance that there should be some authority which
will control the credit creation by commercial banks. As controller of credit, the central bank attempts to influence and
control the volume of Bank credit and also to stabilize business condition in the country.

Role of Central bank in a developing economy

         The modern central bank is an institution responsible not only for the maintenance of economic stability; it
also performs a variety of developmental and promotional functions which were regarded in the past as being outside
the normal purview of central banking. The main objective of a central bank’s monetary policy is to achieve growth
with stability within the framework of the general economic policy of the State. For the sake of economic development,
the central bank should provide sufficient quantity of money appropriate to growth process. A growing volume of
production and investments cannot be maintained without an increasing supply of money, and credit. The money
supply should grow at least at a rate roughly equal to that of increase in real income. It may be essential to mobilize
domestic savings for productive uses and the flow of funds ahs to be guided, qualitatively as well as quantitatively, to
proper lines of investment. Thus, one of the major functions of a central bank is to support the gradual expansion and
proliferation of commercial banks, savings banks, cooperative banks, investment banking, government bond market,
bill market, etc. for the purpose of meeting the requirements of economic developments of the country. The central
bank has also the responsibility to publish statistical reports on trends in the money and capital markets.

          In a developing economy, particularly, the central bank has important roles to play in the process of
development. The under-developed economies have under developed money markets where banking system is not
properly organized. There are institutional gaps in the money and capital markets which hinder economic growth.
Thus, promotion of sound, organized, well-integrated institutions and agencies of money and capital markets
becomes the important function of a central bank in a developing economy. The Planning Commission in India has
stressed the developmental role of central bank in these words. “Central banking in a planned economy can hardly
the confined to the regulation of the over-all supply of credit or to a somewhat negative regulation of the flow of bank
credit. It would have to take a direct and active role, first, in creating or helping to create the machinery needed for
financing development activities all over the country and secondly, in ensuring that the finance available flows in the
directions intended”.

        Some vital sectors, like agriculture, small industries, etc., in the developing economies have suffered due to
unsatisfactory organization for the supply of credit to these sectors. The central bank ahs the responsibility to improve
the position by making special efforts for providing credit facilities to these ‘priority sectors’ on relatively easier terms.
The central bank is also required to make adequate arrangements for the expansion of long-term finance for
industries, some separate institutions may have to be created for the purpose. The central bank also meets a part of
the requirements of the government finance through deficit finance, the magnitude of which has to be decided
carefully so that economic stability is not greatly impaired.

        In developing economies, in fact, the development aspect of central banking functions is of greater
importance than its regulatory aspect. According to Edward Nevin, the usefulness of a central bank in a developing
economy must be stressed primarily in terms of its ability to assist the process of economic growth and capital
formation, the contribution it can make to the regulation, direction and guidance of such credit institutions as exist at
the time must be of secondary and lesser consideration.

        The objectives of central banking policy in a developing economy may, this be stated as follows:

    1. To assist in the mobilization of savings in the community and promote capital formation.
    2. To promote the spread of monetization and monetary integration through the development of an integrated
       commercial banking system.
    3. To make adequate provision of credit necessary for fulfillment of the targets of production and trade.
    4. To extend monetary support to the authorities in the central task of allocation of resources among different
       sectors in the economy.
    5. To help in maintaining general price stability and preventing inflationary tendencies from getting out of hand.

    Thus, in a developing economy, the central bank will actively participate in the growth process and create
    favourable conditions for fostering growth with stability.

                                                      LESSON – 10

                                CENTRAL BANK – METHODS OF CREDIT CONTROL

         In the last chapter, we saw how credit control is an important function of the central bank. Various weapons or
methods are available to a central bank to control credit creation and contraction by commercial banks. Some of
these weapons are traditional and have been in use for decades while some have been developed and perfected only
in recent years. Some are called quantitative controls, since they are supposed to control and adjust total quantity or
the size or the volume of deposits created by commercial banks, they relate to the volume and costs of bank credit in
general without regard to he particular field of enterprise or economic activity in which the credit is used. There are
other methods of credit control known as particular or selective or qualitative controls, since they control certain types
of credits and not all credits.

         As example will illustrate the distinction between quantitative and qualitative controls. Suppose the Reserve
Bank of India – the central bank in this country-believes that the safe limit for credit expansion is Rs. 5,000 crores but
at a given time the actual bank credit is Rs. 6,000 crores. The Reserve Bank may use bank rate and certain other
weapons to reduce the quantity of credit from Rs. 6,000 crores to Rs. 5,000 crores. Such methods of control are
quantitative. On the other hand, the Reserve Bank may feel that the inflationary pressure in the economy is due to
commercial banks’ loan to speculators and hoarders who have worsened the supply situation so as to push up the
price level and, hoarders. The control here is selective or qualitative since the influence is on a particular type of
credit. Quantitative control are traditional and indirect while selective controls are modern and direct.

        Quantitative controls consist of bank rate or discount rate policy, open-market operation and reserve
requirements. Qualitative controls consist of regulation of margin requirements regulation of consumer credit, control
through directives moral suasion, rationing of credit and direct action.

Quantitative Methods

1) Variation of the Bank Rate:
         Bank rate is the official minimum are at which the central bank discounts approved bills of exchange or
advance loans against approved securities to the commercial bansk and the discount houses. Broadly speaking the
bank rate is the lending rate of the central bank. When the bank rate is raised, the market rate of interest tends to rise.
This discourages new loans and puts pressure on debtors to repay their existing loans. Thus a rise in the bank rate
leads to contraction of credit. Money does nto leave the banks. On the other hand money flows into the banks
because more people may now save more money and deposit it in the banks. Funds may flow in, even from abroad,
as the raising of the bank rate is followed by the raising of interesst on deposits. The contraction in the volume of
credit and money supply following a rise in the bank rate leads to a fall in prices. This will encourage exports and
discourage imports. The fall in prices will also discourage investments and employment. Thus a rise in the banks rate
will discourage borrowing, encourage saving, and thus lead to a contraction in the volume of credit and money supply.
         The interval between the rising of the bank rate and the decline of the prices may be considerable. Bank rate
is raised during periods of rising prices and infavourable balance of payments position. Conversely when bank rate is
lowered it will lead to an expansion of credit and cause a rise in prices. A low bank rate will naturally lead to an
increased borrowing and spending. It will lead to increased investment and employment. A low bank rate is usually
fixed then prices show a tendency to fall.
         Limitations : There are some serious limitations to the effectiveness of the bank rate policy in controlling
credit. Firstly, the changes in the banks rate not only affect the money market rates and consequently the supply and
demand for bank credit. But under certain conditions, they also lead to enormous international movements of capital
and the central bank in a particular country which is considered safe for foreign investments, will find that there is an
increased inflow of foreign capital into the country consequent on the rise in the bank rate. The consequence would
be an increase in the supply of foreign exchange value of the country’s currency which would temporarily become
over valued. This would discourage export from this country to the determent of national interest. As changes in the
bank rate directly influence the inflow and outflow of capital with far reaching effect on exchange rates, changes in the
bank rate are not likely to be made.
         Changes in the bank rate affect the prices of government securities. An increase in the bank rate would
depress the prices of government securities. This might affect not only government’s credit but also the value of the
assets of the commercial and other banks which hold government securities. The central bank therefore does not
change the bank rate with out careful consideration of the consequence of its policy on the assets of the banking

         Finally the effectiveness of the changes in the bank rate in a country depends on the stage of development of
its money and the way in which the different money market rates move with the bank rate. In a country like India
where the money market is yet to be properly developed and where the money market rates are not altogether
dependent on the bank rate and where there is still a large non-monetized sector (Indigenous banks and money
leaders) on which the central bank has no control, the effectiveness of the bank rate as an instrument of monetary
policy is considerably reduced.

2. Open-market operations

         Deliberate and direct buying and selling of securities and bills in the money market by the central bank, on its
own initiative, is called open-market operations.The theory of open-market operations is as follows:

        In periods of inflationary situation, the central bank will sell in the market first class bills in its possession.
Buyers of these bills-whether they are commercial banks themselves or others-make payments to the central bank
through commercial banks. Since commercial banks hold certain reserves or deposits with the central banks,
payment by the former to the latter actually means reduction in the size of the cash reserves held by the commercial
banks with the central bank. Reduction of cash reserves forces commercial banks to reduce their loans and advances
and at the same time to refuse loans. Thus, investments activity in the country, which is based on bank loans and
which is responsible for boom conditions, will be cut short.

         In times of depression, the central bank will buy bills in the market, for which it will pay cash to the commercial
banks. When the commercial banks find their cash reserves increased, they expand their loans and advances and
thus help in the expansion of investment, employment, production and prices. Thus by buying and selling securities in
the open market, the central bank in influences the credit operations of commercial banks and ultimately business
activity and economic conditions in the country.

Superiority of Open-market Operations over Bank Rate

         Strategically, open-market operation, as a method of influencing the money supply, is superior to bank rate
policy, primarily because of the fact that the initiative is kept by the central bank itself, while the effectiveness of
discount rate policy will depend upon the commercial banks. For instance in correcting an inflationary situation, the
central bank may sell securities in the market and thus reduce the cash reserves of commercial banks, with less cash
reserves the latter may be expected to reduce their loans and advances. But in the case of discounts, the central
bank cannot do more than establish a bank rate until a commercial bank applied for credit accommodation. Bank rate
policy is, therefore, passive in the sense that its success depends upon the willing response of the commercial banks
and their customers to changes in the bank rate.

        The open-market operations policy has important uses. In the firs place, open-market operations are used to
support the bank rate policy and make it effective. For example, in a period of depression, the monetary authority will
lower the bank rate and attempt to bring about a cheap money policy, at the same time; it will buy securities from the
market and thus provide additional cash to commercial banks so as to enable them to increase their loans and
advances. Open-market operations are, therefore, used to create and maintain conditions of cheap money as an aid
business recovery.

         Secondly, open-market operations are used to support government securities. By buying government
obligation (bills and bonds) when the price is ruling low and selling them when their price is high, the central bank can
bring about stability in the price of government securities.
         Thirdly, such operations influence the internal prices and wages and thus influence the movements of the
balance of payments as well as the inflow and outflow of gold. For instance, the selling of securities in the market by
the central banks will reduce the cash reserves of commercial banks which will contract their loans and advances. A
deflationary situation will result with falling prices and wages. The country’s exports will be stimulated (because of
increased foreign demand due to lower prices) while its imports will decline (because prices in foreign countries are at
a higher levels compared to local prices). A favourable balance of payments will result, and under gold standard, gold
will move into the country.

       Lastly, open-market operations are used to offset the seasonal movements in the economy due to the
presence of too much money (during the slack season) or financial stringency (during the busy season). Excess
money is drained of the money market through the central bank selling securities, the financial stringency is sought to
be overcome through purchase of securities from the market for which the central bank provides cash. Thus, open-
market operations have come to be recognized as an important technique of monetary management.
Limitations of Policy of Open-Market Operations

         The success of the open-market operations depends on one important assumption, viz, whenever
commercial banks find themselves with additional cash. They will expand credit and whenever they find their cash
reserves reduced, they will contract credit. This assumption, however, may not hold good in practice, particularly in
abnormal times. We have shown earlier how the credit expansion and contraction reflect, to a great extent, the
prevalent mood of businessmen and bankers. In boom periods, optimism prevails all round and bankers will be
tempted to expand credit as much as possible and will not be unnecessarily worried even if their cash reserves at the
central bank are reduced by the open-market operations. Two alternatives are open to commercial banks to
neutralize the open-market operations policy. The commercial banks may elect to work with low reserve, or they may
replenish their cash by discounting some of their eligible bills at the central bank.

        During periods of depression and falling prices and growing unemployment, commercial banks will not
expand credit despite higher cash reserves (through the bank buying securities from the market and paying cash
against them). As a business depression is dangerous to companies and banks, the latter may elect to work with
higher cash reserves rather than expand credit. Moreover, the central bank, being the custodian of the deposits of the
general public, will not have the moral force to compel commercial bask to lend more and risk the depositor’s money.
Above all, there is the most difficult and formidable problem associated with credit expansion, viz., and willingness of
businessmen to come forward to borrow. Thus open-market operations may not be useful to control a depression and
bring about business revival.

       Finally, there are definite limits to what open-market operations can achieve by way of squeezing the
resources available to banks since the willingness of banks to absorb securities in certain situations is limited.
Moreover, they cannot be effectively used in an undeveloped country like ours as all the conditions necessary for their
success do not exist here.

         To conclude, the open-market operations method has been significant only after World War I and in the year
after 1931, it has become a recognized and regular technique of monetary management. As open-market operations
affect the liquidity of commercial banks and consequently the amount available for lending or investing, they have
been considered very powerful for influencing the volume of bank credit and money. However, this weapon is
generally used as a subsidiary instrument to support the bank rate policy.

3) Variation of the Reserve Ratio or changes in the minimum cash reserves of              commercial banks

        With a view to enable the central banks to have control over the money market and to enable it to control the
capacity of the commercial banks to expand or contract credit, the central bank is given the power to decrease or
increase the minimum cash reserve (Reserve Ratio) which the commercial banks are required to keep with the
central bank. The reserve ratio is the compulsory minimum percentage of the time and demand liabilities which the
commercial banks must keep as deposit with the central bank.

The central bank might not always find it possible or profitable to engage in open market operations. For eg. When
there is a shortage of securities to buy and sell or when it considers it unprofitable to buy securities at higher prices or
to sell securities at lower prices. Under such circumstances, the power is given to the central bank to decrease or
increase the reserve ratio. Obviously it helps to increase or decrease the volume of bank credit. When the reserve
ratio is increased, the banks will have a smaller amount of cash reserves for credit creation. Open market operations
and variation of the bank rate may prove to be ineffective so long as the banks posses a large volume of reserves. So
the power to change the reserve requirements of commercial banks gives the central banks an additional weapon to
use, to bring about the desired change in the supply of bank credit.

           The Reserve Bank in India can ask the scheduled banks to keep with it up to 15% of their demand and time
liabilities. Further the Reserve Bank may require the schedule bank to maintain with it additional cash reserves in
relation to the excess of demand and time liabilities above a certain level on a particular date. But here also there are
some limitations. For instance it has been pointed out that the surplus reserves are not equally distributed among the
banks of country and it is therefore likely that when reserve requirements are increased, some bank will be affected
more than the others. Secondaly like open market operations, the changes in the reserve requirements will also be
the effect of increasing or decreasing the available supply of banking money. But such changes do not always bring
about corresponding or proportionate changes in the volume of credit actually created either because the commercial
banks do not always increase or decrease their loans and investments in accordance with the increase or decrease in

the available supply of cash or because the demand for bank credit does not always increase or decrease

       Hence although the method of changing the reserve ratio of banks is an effective method of bringing about
changes in the supply of bank credit, much moderation and discretion are necessary in its use.

Selective Control

         The quantitative controls given above affect indiscriminately all sections of the economy which depend upon
credit. For example, when the bank rate is raised and borrowing is made more costly, all those who have depended
upon bank credit will have to suffer. But then there may be many groups of borrowers who may be engaged in
important sphere of economic activity and whom the central bank will definitely like to exempt. Quantitative controls,
being general controls, affect indiscriminately all industries. To overcome this weakness and to select only those
industries which are sensitive to inflationary pressure selective control were designed during and after World War I.
The special features of selective or qualitative control are:

        (a) They distinguish between essential and non-essential uses of bank credit,
        (b) Only non-essential uses are brought under the scope of central banks controls, and
        (c) They affect not only the lenders but also the borrowers.

        Though the selective controls have come into fashion only in recent years, especially during and after World
        War II, they have been known to central banks much earlier.

Type of Selective Controls

         Selective controls have been used to control the total volume of credit, but basically through cutting down the
credit extended for non-essential purposes or used Loans extended to speculator to hoard goods, or banks credit to
consumers to raise their demand for durable consumer goods will prove to be inflationary when there is already
excessive demand as compared to the limited supply. Essentially therefore selective controls are meant to control
inflationary pressure in a country. They can allow the expansion of bank credit in the essential industries, while they
keep in check banks credit to non-essential industries. For, additional credit in the former case will raise the level of
production and real income. On the other hand, loans given to non-essential industries will contribute only to
accentuating inflationary pressure. Important selective control is given below:

(i) Margin Requirements

         Before the stock market crash of 1929, in U.S.A. there was extensive speculation in stock markets in America
and the Federal Reserve Banks of America ordered commercial banks to restrict their loans and advances to stock
brokers by raising their margin requirements. Since then, many central banks have been following this method of
controlling credit to brokers and speculators in the stock exchanges and commodity markets. The operation of margin
requirements is simple and direct.

         A commercial bank does not lend up to the full amount of the value of a security but lends something lower.
Suppose, a security is worth Rs. 1,000, the bank may lend up to Rs. 700 and keep a margin of Rs. 300. The bank is
said to keep a 30 per cent margin as a cushion against the decline in the value of the security. Commercial banks
may be directed by the central bank of the country to fix higher or lower margins. Suppose, commercial banks are
ordered to keep 40 per cent margin, then they can lend up to 60 per cent of the value of a security. If the margin is
raised to 100 per cent, the bank can lend nothing. A 100 per cent margin requirement was actually fixed by the
Federal Reserve Banks in 1946-47 to control the stock market boom which was pushing up the inflationary pressure
in the U.S.A. A higher margin will reduce the amount of loans given by the commercial bank and this weapon will be
used at a time of inflationary situation, a lower margin will increase the amount of loans given by the banks and this
will be resorted to in period of depression when the monetary authorities want to expand the level of economic activity
in the country.

(ii) Regulation of Consumer Credit

       Originally used in the U.S.A. since the beginning of World War II, regulation of consumer credit is now being
used extensively in many countries. During World War II, an acute scarcity of goods was felt and the position was
worsened in the U.S.A. by the system of bank credit to consumers to enable them to buy durable and semi-durable
consumer goods through installment buying. This was responsible not only for intensifying the inflationary pressure in
the country but also in disturbing production of goods for defense purposes. The Federal Reserve Banks of the U.S.A.
were authorized to regulate the terms and conditions under which consumer credit was extended by commercial
banks The restraints under these regulations were twofold: (a) The limited the amount of credit for the purchase of
any article listed in the regulation; and (b) they limited the time for repaying the debt.

          To tae an example, suppose a buyer was required to make a down payment of one-third of the purchase
price of a refrigerator and pay the balance in 15 monthly installments. Under the regulations restraining consumer
credit, the down-payment was made larger and the time allowed shorter. The result was a reduction in the amount of
credit extended for the purchase of refrigerators and the time it was allowed to run, and the ultimate result was the
contraction in the demand for refrigerators and other non-essential goods at a time when there was a shortage in
supply and when there was a necessity for restriction consumer-spending. This measure was a success in America in
controlling inflationary pressure. In the post-war period, it has been extensively adopted in al those countries where
the system of consumer credit is common.

Monetary authorities have come to recognize the significance of restriction of consumer credit. For instance, in the
period of prosperity and inflationary conditions, consumers’ purchases on installment will tend to be large, while
during periods of depression they may fall of dangerously worsening the depression still further. It is, therefore,
generally considered essential to regulate consumers’ purchases by prescribing stiffer terms in a boom period and
permitting easier terms during a deflation and thus reduce come what the extreme fluctuations in business conditions.

(iii) Control through Directives

         In the post-war period, most central banks have been vested with the direct power of controlling bank
advances. This power has been granted to the central banks either by statute or by mutual consent between the
central bank and commercial banks. For instance, the Banking Regulation Act of India, 1949, specifically empowers
the Reserve Bank of India to give directions to commercial banks in respect of their lending policies, the purposes for
which advances may or may not be made and the margins to be maintained in respect of secured loans. The Reserve
Bank can also prohibit any particular bank or the banking system as a whole against entering into any particular
transactions of class of transactions. Since 1956 the Reserve Bank of India has made use of the method quite
frequently. In England, the commercial banks have been asked to submit to the Capital Issue Committee all loan
applications in excess of 50,000. In many cases, this control may be exercised through the help of directives issued
by the Government or the monetary authorities, as well as through certain formal and its credit institutions. The
effectiveness of “directives” will depend to a large extent on the prestige of the central bank.

        There is no uniformity in the use of directives to control bank advances. On the one extreme, the central
banks may express concern over credit developments the concern may be combined with mile threat to avoid
increase or decrease in the existing level of bank loans. On the other extreme, there can be clear and open threat to
the commercial bunks financing certain types of activities. In many cases directives given by the central banks may
be complied with but may not be liked by the banking system. In England, there has been considerable discussion
regarding the propriety of this method. In England, there has been considerable discussion regarding the propriety of
this method. But there is no doubt about its effectiveness.

(iv) Moral Suasion

Moral sussion implies persuassin and request made by the central bank to the commercial bank to follow the general
monetary policy of the former. In a period of depressin, the commercial banks may be persuaded to expnd their loans
and advances to accept inferior types of securities which they may not normally accept, fix lower margins and, in
general, provide facourable conditions to stimulate bank credit and investment. In a period of inflationary pressure,
the central bank may persuade commercial banks not to apply for further accommodation or not to use the
accommodation already obtained for financing speculative or non-essential activities.

         There is some doubt about the effectiveness of moral suasion. Some have expressed the opinion that moral
suasion as a method of credit control cannot be really successful, it may have restraining influence, but when forces
making for expansion or credit contraction are very strong, moral suasion “without nay teeth in them” will be
ineffective. On the other hand, taking the example of England, some have argued in favour of moral suasion. The
Bank of England has used this method with a fair measure of success. But this has been mainly because of a high
degree of co-operation which it always gets from the commercial banks. While the method has the psychological
advantages as it does not carry any threat or legal sanction, it may not be very effective in times of emergency.

(v) Rationing of Credit

         Credit rationing is a method of controlling and regulating the purpose for which credit is granted by the
commercial banks. Credit rationing may assume two forms. The first-known as the variable portfolio ceilings refers to
the system by which the central bank fixes a ceiling or maximum amont of loans and advances for every commercial
bank. The second-known as the variable capital assets ratio-refers to the system by which the central bank fixes the
ratio which the capital of the commercial bank should have to the total assets of the bank (or to any category of
assets). In other words, rationing of credit is a method by which the central banks seeks to limit the maximum or
ceiling of loans and advances and, also in certain cases, fix ceiling for specific categories of loans and advances. If
the rationing of credit is done with reference to the total amount, it is a quantitative control, but if it is done with
reference to specific types of credit, it assumes a qualitative character.

         Rationing of credit may also be taken in sense, i.e., it refers to the power of a central bank to allow only a
fixed amount of accommodation to member-banks by means of rediscount. Normally, this may not be used since it is
not compatible with the function of a central bank as the lender of the last resort. It is, however, maintained the
rationing of credit has a significant role to play in a planner economy, in diverting financial resources into the channels
fixed by the planning authorities. But if cannot be denied that the freedom and initiative of commercial banks is
severely curtailed by credit rationing.

(vi) Direct Action

         Direct action one of the extensively used methods of selective control. It has been followed by almost all
banks at some time or the other, and in a board sense, it includes all the other methods of selective credit controls.
But, more specifically, direct action refers to all the controls and direction which the central bank may enforce on all
banks or may banks in particular concerning lending and investment. If the central bank is aware that the banking
system has made use of bank credit for speculation in securities or in commodities it may adopt suitable measures to
restrict credit and penalize the offending bank or banks. To cite an example of direct action, the Reserve Bank of
India issued a directive in 1958 to the entire banking system to refrain from excessive lending against commodities in
general and forbidding commercial bans from granting loans in excess of Rs. 50,000 to individual parties against
paddy and wheat. The directive was an immediate success.

         Direct action can also take the form of the central bank charging a penal rate of interest for money borrowed
beyond the prescribed amount or refusing to grant further rediscounting facilities to he erring banks. There is no doubt
about the effectiveness of such direct action but then the element of force associated with direct action is resented by
the commercial banks. In many cases, commercial banks themselves may not be responsible for the way loans are
spent by the parties-it is always possible for a firm to borrow for one purpose and spend it for some other purpose. It
many cases, unless the monetary authorities clearly specify, it may be difficult to distinguish between essential and
non-essential industries, productive and unproductive activities, and between investment, speculation and gambling.
Finally, direct action ahs been criticized on the ground that it results in division of responsibility between the central
bank and commercial banks. For instance, the commercial banks continue to extend credit till they are stopped by the
central bank. The former are continuously operating under fear of direct action by the central bank. Such a perpetual
fear may result in open evasion of central banks regulations by some and confused observance by others.

                                                     LESSON – 11

                                                   MONEY MARKET

Financial markets in general; like the commodity markets and the real estate markets are part of the vast system of
exchange and division of labour which goes to make up the modern economy. The financial markets are generally
classified as the ‘capital market’ and the ‘ money market’.

         In Economiecs, the term market does not mean any particular place where things are bought and sold but the
whole of any reagion in which buyers and sellers are in such free intercourse with each other that the price of the
same commodity tends to be equal. As such, the capital market is primarily concerned with transactions in funds for
relatively long terms use. The money market, on the other hand, includes the entire machinery of the channeling of
short term funds. This lesson undertakes to describe the money market and what goes on it.

The Money Market-Its definition

         As already stated, money market is a market for the lending and borrowing of short term funds. It is a
mechanism through which a large part of the financial transactions of a country is cleared. It is essentially a reservoir
of short term funds and is concerned with the buying and selling of temporary surplus funds. It does not deal in cash
or money but in trade bills, promissory notes and governments papers which are drawn for short periods. These short
term bills are knows as near money.

        Defined most simply, a money market may be described as “the centre for dealings, mainly of a short term
character, in monetary assets, it meets the short term requirements of borrowers and provides liquidity or cash to the
lenders. It is the place where short term surplus investible funds at the disposal of financial and other institutions and
individuals are bid by borrowers, again comprising institutions and individuals and also by the government” (The
Reserve Bank of India – Functions and Working). According to G. Crowther “It is the collective name given to the
various firms and institutions that deal in the various grades of near money”.

         The money market has no single meeting place. Negotiations are carried on through the telephone, the
telegraph and the mail. A geographical name may be given to the money market according to its location. Examples,
are the London money market, the New York money market and the Bombay money market. The London money
market operates largely in Lombard Street through dealers and bankers talking over the telephone. It attracts short
term funds from all over the world and it is recognized as an international scope and operate largely in Wall Street.
The Bombay money market is the centre where short term loanable funds of not only Bombay but the whole of India
are attracted and are quickly borrowed and lent.

         The dealers in the money market consist of the Governments. Commercial and industrial concerns, stock
exchange brokers, dealers in government and other securities, merchants, manufacturers, farmers etc. commercial
banks and the central bank. The demand for funds for short periods comes from the government business and
industrial concerns and other individuals. The Governments has become probably the biggest borrower everywhere,
money being required to meet current deficits. Industrial and commercial concerns borrow funds for working capita
needs. Sometimes they borrow to enable them to carry additional stocks. The stock brokers, merchants and other
need short terms funds for various purposes. Commercial banks themselves may require additional funds and may
borrow from the central bank or from each other. The supply of loanable funds in the money market comes mostly
from the central bank of the country, the commercial banks and other finance companies. The central bank is the
primary source of credit to commercial banks while the latter constitutes the most important sources of short term
credit in both individuals and business houses and also to stock exchange brokers.

        Money market may be distinguished from capital market. The capital market is concerned with the supply of
and the demand for long term investible funds, while money market is concerned with short term funds. The short
term funds dealt in a money market may be required for a period not exceeding six months where as the funds dealt
in Capital market may be required for a period of more than 5 years.

        Instruments such as bills of exchange, treasury bills, and short term governments bonds are, used in the
money market. Long term securities such as shares and debentures of industrial concerns, debentures and bonds of
quasi government’s organization and bonds and promissory notes of the government are used in the capital market.
Such long term securities are called the stock exchange securities.

          In addition to the above said differences, there is also another difference of institutional control. A special set
of institutions deals in long term funds. They may be called as investment banks, money lenders, brokers or by any
another name. They constitute the various elements that go to make up the capital market in a country. A different set
of institutions deals in short term funds. They mainly consist of commercial banks and discount houses.

          In practice both money market and capital market are interrelated and there is a certain amount of
overlapping between transactions in short term and long term loans. The same institutions many a time deal in both
types of loans and thus may operate in both markets. The volume of transactions in one market greatly influences the
conditions in other market. Since the two markets are intimately related to each other, some writers do not make any
distinction between the money market and the capital market.

Composition of the money market

         The money market is not single homogenous market but it is composed of several sub markets, each one of
which deals in different types of short term credit. However, as such money market has different types of submarkets,
it is impossible to speak about the composition of a money market in general, without specifying the market that is
being studied. The most important components of the money market which are common to most money markets are
described below:

1. Call Money Market

        It refers to the market of extremely short period loans. These loans are given up to seven days but more often
        from day to day or overnight only. These loans are known as call money or call loans since the lending banks
        can call them at the shortest possible notice. Such loans are provided by commercial banks to bill brokers
        and dealers in the stock exchange who require financial accommodation for short period to finance their
        customer’s trading on margin and their own holdings of securities When money is called by one bank, it can
        usually be reborrowed from another and a circulating fund is there by kept in constant employment. Call loans
        are found useful by banks for more than one reason. First of all since call loans can be converted to cash at
        any time, they are almost like cash and form the second line of defence for banks after cash. Secondly unlike
        cash, they bring some income for the banks. The call money market, composed of commercial banks as
        lenders and stock exchange brokers and dealers as borrowers, has always been a very important segment of
        the money market.

                There may also be an inter-bank call money market where the demand on excess reserves balances
        of certain banks comes from other banks that need to command such balances in-order to adjust their
        reserve positions to accord with existing statutory requirements.

2. Acceptance Market

        It refers to the market for bankers acceptances which arise out of trade-both inland and foreign. When goods
are sold to any one on credit, the buyers accepts a bill. Such a bill cannot be discounted anywhere easily. The banker
adds his credit to the bill by accepting it on behalf of his customer who has purchased the goods. Thus a banker’s
acceptance may be described as a draft drawn by an individual or a firm upon a bank and accepted by the bank,
ordering it to pay to the bearer or to the order of he designated party a certain sum of money at a specified future
date. The banker’s acceptance market. In the London money market, there are specialist firms known as acceptance
houses which accept bills drawn on them by traders instead of drawing on the true debtors. The acceptance market
enjoyed a prominent place as a segment of money market in the past. However its importance has declined
considerably now.

3. Bill Market

        Bill market of the discount market refers to the market in which short dated paper or bills are bought and
should. The bills of exchange and the treasury bills are the most important types of short dated papers. The bills of
exchange is an unconditional written order signed by the drawer requiring the party to whom it is addressed to pay on
demand or at a specified future date a certain sum of money to the order of a specified person or to the bearer. It is a
commercial paper which can be discounted by commercial banks to get financial accommodation. Treasury bills are
an IOU or the promissory note of the government to pay a specified sum after a specified period, generally 91days
from the date of issue. Treasury bills are generally sold by the central bank on behalf of the government.
        Before the First World War the most impotent pepper discounted in the London money market was the
commercial bill which was used to finance both inland and foreign trade. During the inter war period the importance of
the commercial bills declined. Their place has been taken by the treasury bills. In view of their unparallel excellence in
liquidity and marketability, treasury bills are heavily bought by commercial banks for the purpose of maintaining their
secondary reserves.

4. Collateral Loan Market

         It refers to the market for loans secured by stock and bonds or collateral loans. In its appropriate sense, the
collateral market implies the market for collateral loans to brokers and dealers in securities, either on call or for a
comparatively short period of time. The importance of the collateral loan market has declined since the stock market
crash of 1929.

        It should be pointed out that the different markets which collectively form the money market can, in fact be
combined into one market. The call money market, for example refers to the borrowing and lending of call loans and
advances. The borrowers are those who deal in discount market. Again the acceptance market refers to the
acceptance of bills and properly speaking, acceptance of bills naturally leads to the discounting of bills, (in the
discount market). Therefore all the markets which comprise the money market can be combined into one market and
may be designated as the discount market.

        While speaking about the composition of the money market some writers speak about the bond market, the
government long term loan market, the new issues market, the stock exchange and so on. But these markets properly
belong to the long term capital market and not to the short term money market.

Apart from these institutions of the money market, there is the central bank of the country, which, as the ultimate
authority and controller of monetary and banksng conditions in the country, is the accepted leader of the money
market. The Central Bank has the responsibility to control and guide the institutions of the money market and towards
this end; it is armed with both qualitative and quantitative weapons of credit control.

Characteristics of developed and Undeveloped money markets

        In every country of the world, some type of money market exists, but while some of these are very highly
developed, a good man is still undeveloped. Professor S.N. Sen has described the characteristics of a developed
money market in his well known book ‘Central Banking in Undeveloped Money Markets’. The absence of one or more
of these conditions will make a particular money market an undeveloped one. The features of a developed money
market are discussed below:

1. A well organized banking system

        A developed money market is characterized by the presence of a well organized commercial banking system.
A well developed banking system is one that can meet all the reasonable needs of the country. In a developed money
market, commercial banks constitute the nucleus of whole money market. They are the most important suppliers of
short term funds and therefore, any policy they follow regarding loans and advances and investments will have
repercussions on the entire money market. Because of their intimate relations with the central bank of the country,
they serve as a connecting link between the various segments of the money market and the central bank.

          In a developed money market, the commercial banks tend to employ their cash reserves more economically.
This is evidenced either by the emergence of more or less stable behavioural patters with regard to cash ratios or by
the acceptance of lower cash ratios. Occasionally there may be elements of both. The more economical use of cash
is an important by product of truly integrated baking structure grouped around a central bank that is capable and
willing to act as a true lender of last resort. Thus a fully developed money market is characterized by the presence of
a highly organized commercial banking system, whereas in an undeveloped money market, the banking system is not
fully developed.

2) Presence of central bank

        Just as a state control function properly without a government, so also a money market cannot function
properly without a central bank. A strong central bank is an essential prerequisite for the more economical
employment of cash by permitting banks to maintain either relatively stable or lower cash ratios. There are man
countries where banking business is subject to quite market seasonal fluctuations. In such condition banks can have
recourse to the Central bank against the lodgeemnt of security on those occasions when the pressure of demand for
loans and/or cash is heavy. Through rediscounting of eligible bills the central bank enables the money market ot
convert near money assets into cash in times of crisis. Besides it performs a valuable serice through open market
operations when it absorbs surplus cash during off seasons and provides additional liquidyt in times of financial
stringency. Thus the central bansk to the banking system is like a commander to the army, it is the leader of the
money market, as well as its controller and guide. A developed money market cannot exist without an efficient central
bank. A developed money market cannot exist without an efficient central bank. In an underdeveloped money
market, the central bank does not exist or if it exists, it is not in a position to influence and control the money market.
        Through the existence of a well organized banking system and a central banks are the essential
preprequisites for the development of a well organized money market these requisites alone are not sufficient.
Professor Sen cites example of Australia where the banking system including the central bank has made remarkable
progress and is very we4ll developed but there is no organized money market. Professor Sen is therefore correct
when he says that besides a well organized banking systems and an efficient central bank, other factors should also
be present for the existence of a well organized and well developed money market.

(3) Availability of proper credit instruments:

          A developed money market will require a continuous supply of highly acceptable and negotiable instruments
like bills of exchange, treasury bills, short term government bonds etc. A developed bill market is an essential
characteristic of a developed money market. It is also essential that there should be a number of dealers and brokers
in the money market who are prepared to deal in bills and securities. These dealers and brokers are responsible for
borrowing funds from the banks and using them to buy and hold short term assets. Without their presence there
cannot be any competition or ‘life’ in the money market. Thus the availability of adequate short term assets and the
presence of dealers and brokers to deal in them are essential conditions for the evolution of an organized and
developed money market. An undeveloped money market is characterized by the absence of sufficient short term
security as well as dealers and brokers to deal in such securities.

(4) Existence of a number of sub markets:

         Another features of a well developed money market is the existence of number of sub markets, each
specializing in a particular type of short term assets. The London money market, which is probably the most
developed in the world has well developed Call money market, the acceptance market, the Commercial market, the
foreign exchange market and so on. Each type of short term asset has a specialized sub market. Professor Sen
observes, “The larger the number of sub markets, the broader and more developed will be structure of the money
market”. Two important points should be emphasized as regard the existence of sub markets.
         Firstly, in order to specialize each sub market should consist of a good number of dealers and should posses
adequate sources of supply of funds for dealing in particular short term assets.

        Secondly the sub markets should be intimately connected to each other. Specialization should not be
confused with ‘Compartmentalization’. This essential for the free flow of funds from one market to another, for the
existence of a common rate of interest in all sub markets and for the effective control of the entire money market by
the central bank.

        An undeveloped money market, on the other hand does not posses all the important and essential sub
markets, especially the bill market. There is also absence of coordination between the different sections of the money
market, if it is undeveloped.

(5) Perfect mobility of funds

        A fundamental requirements of a developed money market is the free movement of money and of monetary
assets, so that temporary surplus funds can be absorbed at points in the system where there is a demand for them.
This ensures a tendency towards equality of rates for similar types of business even at wodely separated points in the
economy. Moreover, a developed money market requires ample resources to finance the dealings in the various sub
markets. These resources generally come from within the country, but it is also possible that foreign funds may also
be attracted. The London and New York money market attract funds from all over the world. Undeveloped markets do
no attract foreign funds due to political instability and absence of stable exchange rates and even internal mobility
may be a problem.

(6) Existence of an integrated structure of markets and institutions:

        Integration of structure is considered to be the most essential characteristic of a development money market.
All other characteristics, in a way are likely to emerge out of an appropriate degree of integration. Integration of
structure assists in economizing cash reserves of banks and assures full employment of such liquid resources as are
available in the market. It also enables the central bank to exert its influence by conferring directly with the respective
groups of interest. In London, for example, the Governor of the Bank of England can at any time call for informal
discussion the chairmen of the Clearing Bankers’. Association

(7) Miscellaneous factors

        Apart from the above conditions, there are also other factors which influence the character of the money
market. A large volume of international trade leading to the availability of bills of exchange, rapid industrial
development leading to the emergence of a stock exchange, stable political conditions, favourable conditions for the
establishment and management of foreign concerns etc. are some of the miscellaneous factors responsible for the
evolution of a development money market.

         Actually speaking, it is difficult to come across any really developed money markets characterized by the
requisites stated above. The London money market however, provides the best example of developed money market.
New York money market is another developed market which has greatly developed in the post world war II years. It
may, however, be emphasized the every country has its own problems and environment. The model of the London
money market has evolved out of its own conditions and environment and may be no justification for its application to
the rest of the world. This model, nevertheless, serve the purpose as a ‘Standard of reference’ According to J.S.G.
Wilson, “Enviornments may differ but the essential characteristics, as distinct from the precise institutional forms,
have a generality of possible application much wider than may at first be conceded”.

                                                     Lesson – 12

                                                  Indian Money Market
        The term ‘money market’ as already defined applies to that group of related market, which deals in short term
assets of relative liquidity such as call money, treasury bills, bills of exchange or other commercial papers and short
dated governments securities, Money market structure, actually shows a wide diversity of form, depending mainly on
the economic set up and environment in a particular country.

Structure of the Indian Money Market

       The most outstanding feature of the Indian money market is its dichotomy. As in most developing countries,
the money market in India comprises two sectors which may be broadly termed as the ‘organised’ and the
‘unorganised’ markets. In between these two sectors of the market, there is the cooperative sector.

The Organised Money Market

         The organized market consists of the Reserve Bank of India, the State Bank of India with its seven associated
banks, nationalized commercial banks, other scheduled and non scheduled commercial banks, foreign banks,
Regional Rural Banks, Development banking institutions and other non banking institutions. Besides there are
financial intermediaries such as call loan brokers, general finance and stock brokers and underwriters.

The Reserve Bank of India (RBI)

         The RBI, which is the central bank of the country was constituted in 1935 under the Reserve Bank of India
Act, 1034, to “regulate the issue of bank notes and the keeping of reserves with a view to securing monetary stability
in India and generally to operate the currecy and credit system of the country to its advantages”. The Bank was
originally constitute as the share holders’ bank but was nationalized with effect from 1 January 1949.
         The Bank is performing a number of functions as a central banking authority and occupies a strategic position
in the money market. It, being the residual source of supply of funds, is the key constituent of the money market.
Under the Banking Regulation Act, 1949, the Bank is vested with large powers of supervision, control, direction and
inspection of commercial banks in the country. The powers originally given to the RBI have been enhanced from time
to time through various amendments to the banking legislation. Further, under the banking Laws (Miscellaneous
Provisions) Act 1963, the RBI has been granted certain regulatory powers over non banking institutions which accept
deposits. Under the Banking Laws (Application to Cooperative Societies) Act, 1965, certain powers have been further
vested in the RBI in the matter of supervision, control, inspection etc., of cooperative banks.

Scheduled Commercial Banks

         Commercial banks are classified under two groups viz., scheduled banks and non scheduled banks.
Scheduled banks are those banks which are included in the second schedule to the RBI Act. They are eligible for
certain facilities especially the facility of obtaining accommodation from the RBI and correspondingly bear certain
obligation towards the Bank. Section 42(6)(a) of the RBI Act prescribes the conditions which a bank must fulfill to
qualify for inclusion in the second schedule. These are:

(i) the bank must have a paid up capital and reserves of an aggregate value of not less than Rs. 5 lakhs.
(ii) it must satisfy the RBI that its affairs are not being conducted in a manner detrimental to the interests of its
depositors and
(iii) it must be a company as defined in the companies Act, 1956 or an institution notified by the Central Government
in this behalf or a corporation or a company incorporated by or under any law in force in any place outside India.

        Scheduled banks from a heterogeneous group. They can be broadly grouped into four categories viz., the
public sector banks, private sector banks, Regional Rural Banks and foreign banks.

        Public sector banks comprise of the State Bank of India group and other nationalized banks. Among the
public sector banks, the SBI stands in a class by itself. It is the largest commercial bank in terms of branches and it’s
the leader in the banking system of the country in terms of deposits and advances too. The state bank of India has
seven associate banks which were formerly the banks of the princely states.

        With effect from 19 July 1969, fourteen major Indian commercial banks, each having deposits exceeding Rs.
50 crores accounting for 72 per cent of aggregate deposits of all scheduled commercial banks were nationalized. Six
more banks were nationalized on April 15, 1980. But recently one such bank was merged with another nationalized
bank for lack of viability. Thus at present public sector banks comprise of the State Bank of India with its seven
associate banks and 19 nationalized banks. Those 28 banks, (exclusive of regional rural banks) account for more
than 90% of the banking business in India.

         In addition to a strong public sector set up, Indian money market also houses private sector banks which have
been organized as joint stock companies. In 1969, each one of these had deposits of less than Rs. 50 crores Majority
of them have expanded their business substantially since then. Further, the Government’s latest step of granting easy
entry to private sector banks has given a boost to private sector banking in the country. Now private sector banks are
one of the strong forces in the Indian money market, posing neck to neck competition with public sector banks.

          Regional Rural Banks (RRBs) have been set up in terms of he provision of the Regional Rural Bank Act, 1976
which came into force with effect from February 1976. Each RRB is sponsored by a scheduled bank and is
associated by the sponsoring bank in a number of ways. The main objective of a RRB is to provide credit and other
facilities especially to the small and marginal farmers, agricultural labourers, artisans and small entrepreneurs within
its specified area of operations. They have been included in the second schedule to the Reserve Bank of India Act
and are considered to be scheduled banks.

         Foreign banks also called as the exchange banks are those banks which are foreign in origin and which have
their head offices located outside India. During the early part of he Indian banking history these banks used to wield
great influence in the Indian money market. Their contribution to the development of Indian Joint stock banking has
been significant. Even before 1870, there where certain exchange banks doing business in India. The main business
of these exchange banks is the financing of India’s foreign trade. As a matter of fact banks were established in India
mainly with this object in view. But they gradually entered the field of internal trade and started competing with Indian
banks in attracting deposits of all kinds, discounting bill of exchange and making advances to trade/industry. However
the financing of foreign trade still remains their main field of operation.

Non Scheduled Commercial Banks

        The banking companies other than those included in the second schedule to the Reserve Bank of India Act
are termed as ‘Non scheduled banks’. The business and the number of non scheduled banks have declined steadily
over the years. This is partly owing to some of them attaining scheduled banks’ status, but mainly due to their inability
to conform to the operational standards lain down in the Banking Regulation Act. In 1960, the RBI was given powers
under section 45 of the Banking Regulation Act to secure compulsory mergers and to formulate with Government’s
approval, schemes of reconstruction and amalgamation of banks. There have been a large number of voluntary
amalgamations and compulsory mergers of smaller and weaker banking unit since then. There were only 3 non
scheduled banks functioning at the end of March 1990 as against 335 at the end of June 1960. The non-scheduled
banks thus account for only a negligible part of the banking business in the country.

Development Banks

          Term lending institutions called as development banks have been established for promoting growth of a more
diversified, broad and equitable economic development. Setting up the Industrial Credit and Investment Corporation
of India Ltd. (ICICI) in 1955 marked the beginning of broad based institutional organization of strength. They were
pioneers in institutional underwriting of stocks and shares. The Industrial Finance Corporation of India (IFCI), the first
institute set up in 1948, followed ICICI in this regard. Thereafter came up State Financial Corporations (SFCs) under
the provisions of the State Financial Corporation Act, 1951. The Industrial Development Bank of India (IDBI) was
established in 1964 as the apex institution to coordinate the activities of all term lending institutions. The emphasis on
industrialization during the Third Five Year Plan necessitated the establishment of state-level institution viz.,

        These development banking institutions along with investment institutions such as the LIC, GIC and the
Mutual funds, through primarily confine their activities to the capital market, participate in the money market operation
too on a limited scale.

Post Office Savings Banks

        The oldest of the official small savings scheme in India is the Post Office Savings Bank System. The postal
savings bank is a government agency created for the purpose of encouragement of thrift and attraction of savings.

        Any person can open a Post Office Savings Bank account at any post office which does savings bank work
with a minimum amount Rs. 5 only. Maximum balance upto which interest in permissible in a single account is Rs.
50,000 in case of an individual account and Rs. 1,00,000 in case of an account in joint names. No deposit or
withdrawal in cash is permitted from an account without presenting the pass book at he post office where one has
opened the account. Facility of withdrawal by cheques in also allowed at certain big post offices. Post offices allow the
account holders to nominate one or more persons including minors to receive the balance at the credit of the account
on the death of holder. The Post Offices also operate Public Accounts, Security Deposit, and time deposits. They also
sell National Savings Certificates of different denominations. Many of he deposit schemes were started in early
1970s. The importance of publicizing small savings scheme has received increased attention since then.

Non Banking Companies

          Non banking companies are classified as
(i) non-financial companies, engaged in trading or industrial or other non-financial activities, and
(ii) financial companies, engaged mainly in financing of hire purchase, advancing loans to industries, trading in shares
and securities and companies whose principle business is the acquisition of shares, stocks, debentures or other

The Unorganised Money Market: Indigeneous Banking

        The unorganized money market is largely made up of indigenous bankers and money lenders. The Indian
Central Banking Enquiry Committee defines an indigenous banker of bank as an individual or private firm receiving
deposits and dealing in hundis or lending money. According to the committee those who do no accept deposits were
to be treated as money-lenders. But as was pointed out by the Madras Provincial Banking Enquiry Committee,
receiving deposits could not be treated as the sole distinguishing feature of indigenous bankers. So a better is that of
the Bengal Provincial Banking Enquiry Committee according to which indigenous bankers are defined as ‘individuals
or firms who deal in hundis, whether they accept deposits or not’. Thus the distinguishing feature of an indigenous
banker is dealing in hundis and not acceptable of deposits.

        Indigeneous banking is monopoly of certain castes. They may be grouped as Shroffs, Seths, Sahukars,
Mahajans, Chettis etc., in different parts of the country. They vary in their size from petty money lenders generally
operating in the villages to big indigeneous bankers operating in the towns and the cities whose business, at times,
exceeds that of some of the smaller banks.

The indigenous bankers are to be distinguished from small money lenders in several respects;

(a) while the indigenous bankers receive deposits and deal in hundis (an indigenous credit instrument), rather like a
promissory note), the money lenders do not do so;

(b) the indigenous bankers finance trade and industry, while the money lenders advance small loans to persons
generally of small means.

(c) the indigenous bankers take particular care about the purpose of the loan, while the money lenders are merely
concerned with the interest that they get, and

(d) in the case of indigenous bankers the repayment is more punctual and the rate of interest is lower. The two
groups, however merge on into the other.

        There are three types of indigenous bankers.
    (1) those whose main business in banking
    (2) Those who combine banking business with trading and commission business, and
    (3) Those who are mainly traders and commission agents but who do a little banking business also.

    The majority of indigeneous bankers belong to the second category. They deal as merchants, lend money and
    also do hundi business.
         Indigenous bankers generally rely on their own resources or borrow from one another to carry on their
    business. They also accept deposits. In times of emergency however, they borrow from commercial banks by
    rediscounting hundis. It is an this way that certain links between the commercial bask and the indigenous bankers
    are in existence, but so far as smaller indigenous bankers and money lenders are concerned they have no direct
    links with the organized sector of the money market. On account of the very rigid condition on which banks are
    prepared to lend, the recourse by the indigenous bankers to the organized sector has been declining
    considerably. Since the commercial banks have opened their doors to small industrialists and traders, they do not
    feel any need to route funds through the indigenous banks who charge very high rates of interest. The lack of
    integration between the organized and the unorganized sectors of he money market has resulted into the fact that
    the bazaar hundis rate (i.e. the rate at which indigenous bankers discount hundis at different money market
    centres) is quite different from the bank’s lending rates and the market rates of interest.

         The working of the indigenous bankers suffers from several defects viz., their old and varied methods of doing
    business; lack of distinction between short term and long term finance and also between the purpose of finance,
    their higher rate of interest and the lack of firm integration with the organized sector of the money market. Inspite
    of all these defects they occupy a very prominent position in the Indian money market. They play a very important
    role in as much as they meet the credit requirements of those who do no find easy access to the banking sector.
    Their methods of operations are expeditious and flexible. From the point of view of the borrowers, their chief
    virtue is the absence of formalities and delays besides their easy accessibility.

    Regulation of indigeneous banking

        As early in 1931, the Central Banking Committee had emphasized the necessity of unifying the indigeneous
    and the modern banking sectors of the Indian money market and had recommended the linking of the
    indigeneous bankers with the Reserve Bank of India on the creation of the latter. When the Reserve Bank of India
    was established, it attempted to bring the indigeneous bankers into more direct contact with the organized money
    market. In 1937, it issued a draft scheme offering the indigeneous bankers all the facilities and privileges enjoyed
    by the scheduled banks, subject to their shedding of non-banking business, maintaining proper books of account
    open to the Bank for inspection and the filing of periodic statements similar to those supplied by the scheduled
    banks. The indigeneous bankers, however, were not prepared to accept those conditions and preferred to
    continue the old arrangements whereby they received accommodation from the Imperial Bank and the other
    scheduled banks. Nevertheless the Reserve Bank of India left its offer open and remained ready to take up the
    matter again, if the indigeneous bankers did not decide to conform with its conditions or could suggest any other
    practicable alternative. However the attempts to forge a link between the indigenous bankers and the Reserve
    Bank of India have to materialize so far.

        The Banking Commission 1972, recognizing the useful role of indigenous bankers in the money market,
made some recommendations to introduce a certain measure of financial and social discipline into the activities of
these bankers. Regarding a link of indigenous bankers with the Reserve Bank of India, the Banking Commission
observed that a direct link neither be necessary nor practicable. An indirect influence should be exercised over them
through the medium of commercial banks by laying down guidelines for their dealing with indigeneous bankers,
thereby indicating the type of hundis eligible for discounting, quantum of limits to be sanctioned etc.

         The Banking Commission suggested to codify the practices and usages application to all the indigenous
negotiable instruments like hundi and bring these instruments under the framework of codified low. A code of conduct
for indigeneous bankers should be formulated for their operations and they should be engaged to get incorporated,

        Actually speaking, the Banking commission only repeated and endorsed all the suggestions that had been
made from time to time of linking indigenous bankers to the organized banking sector. It however failed to take into
account the simple fact that the indigenous bankers had seen unwilling all these years to take up this offer on any
terms dictated to them.

        Regarding the small professional money lenders operating in the towns and villages, the state governments
have made various attempts, over a period of years to regulate their activities and to restrict their malpractices
through suitable legislation. In pursuance of the 20 of the 20 point Economic Programme adopted by the then
Congress Government, many state governments passed legislation for moratorium, discharge or scaling down of
debts incurred by small farmers, marginal farmers, agricultural labourers, and rural artisans from private money
lenders. These debt relief measures have resulted by the large in drying up the non institutional sources of credit for
weaker sections of the community. The effect has been virtual disappearance of the professional money lenders from
many areas. Taking into account the risks involved, it has no longer seemed worth his while to operate under the new
provisions. He has therefore chosen to change his calling and to become merchant or trader, though probably he still
carries on an illicit money lending business on a restricted scale. It has become essential to develop institutional
agencies of finance, particularly in the small areas, to meet the credit requirements of the weaker sections of the

Cooperative Sector

        The cooperative credit societies were get up in India in 1904, under the Cooperative Credit Societies Act
passed in the same year. Their main purpose was to supplant the indigenous sources of rural credit, particularly the
money lenders, since the credit provided by the money lenders was subject to many draw-backs and they used to
charge very high rates of interests. Several attempts were made from time to time to improve the structure and the
working of the cooperative credit societies, but they remained in a dormant position for 50 years. In 1954 the Rural
Credit Survey Committee of the RBI had reported that cooperative societies were meeting only 3 percent of the credit
requirements of the farmers in the village whereas the money lenders provided nearly 70 percent of their credit
requirements. On the lines suggested by the committee, some intensive measures were adopted to develop
cooperative societies, to strengthen their capital resources and to increase their coverage. The RBI has helped the
cooperative banks in a number of ways.

The cooperative banks provided both short term as well as long term credit. There is a three tier structure of short
term cooperative credit. At the apex of the whole structure in the state stand the State Cooperatives banks. The
primary Credit Societies at the village level form the base of foundation of the whole structure.

The Central Cooperative Banks, normally at the district level, come in between the State Cooperative Banks and
Primary Credit societies. The long term credit structure consists ordinarily of the central land development banks and
primary land developments banks (or land mortage banks as they were called formerly).

The RBI’s role in building up of the cooperative credit organization has been that of an active collaborator in drawing
up schemes of development with the Government of India and state governments. It has been providing finance first
to the state Governments for contribution to the share capital of cooperative credit institutions at the various level and
secondly to the cooperative credit structure itself to meet its requirementation of the Bank’s role from that of lender of
last resort to that of an active agency for the promotion of an appropriate structure of institutions as well as policies
and procedures for enabling the cooperative agency to take a larger share in the financing of rural credit.

        The National Bank for Agricultural and Rural Development (NABARD) was established on July 12, 1982. This
bank has been taken over from the RBI its refinancing functions in relation to State Cooperative Banks and Regional
Rural Banks. It has also undertaken the entire undertaking of the Agricultural Refinance and Development
Corporation. The capital of the NABARD has been subscribed by the Central Government and the RBI in equal

       The financial facilities provided by the NABARD to cooperative are provided through the state governments,
State Cooperative Banks and the Central Land Development Banks. These facilities consist of short term, medium
term and long term credit.

Characteristics of the Indian Market

        The main characteristics of the Indian Money may be summed up as under:
    (1) The Indian money market has remained divided into two man sectors, which are broadly termed as organized
        and unorganized sectors of the money market. The former concerns itself with modern institutions and
        practices as have developed in advanced western countries. The lattes is derived from indigeneous banking
        practice with a tradition going back many hundred of years. These two sectors are not wholly unconnected
        with each other, but the links which exist are somewhat tenuous and complete integration into a unified
        system has yet to be achieved.
    (2) Non banking companies, both financial and non financial and the other financial intermediaries cater to the
        financial needs of the industrial sector. The cooperation banks which have substantially increased their
        business, operate mostly for the rural or agricultural sector of the economy.
    (3) The RBI has been vested with wide powers of control over different institutions in the money market. The
        indegeneous banking has however remained outside the sphere of the RBI’s direct control. The rate of
        interest in the unorganized sector are therefore, substantially higher than those in the organized sector.

   (4) Indian money market is isolated from foreign money markets. The money markets of advanced western
       countries are characterized by large movements of capital between them, whereas there is hardly any
       movement of funds between the Indian money market and foreign markets. This is partly due to the
       exchanger control restrictions on capital movements.
   (5) The call money market is restricted almost entirely to dealing between banks. The core of Indian money is the
       inter bank call money market. Although the magnitude of funds dealt in this market is not large in relation to
       the deposit resources of banks. Perhaps this is the most sensitive sector of the money market (Reserve Bank
       of India, Functions and Working).
   (6) Considering the demand for funds, there are two seasons in India – the busy season and the slack season.
       The busy season synchronizes with the movements of crops from agricultural centres to market towns. It
       commences from about November every year and continues till about April of the following year. There is
       great demand for funds all over and the pressure for finance on money market increases during this period.
       The slack season starts from about May and end sometimes in October the same year. Funds start returning
       to banks during the slack season. It should, however be noted that there is no exact date when the busy
       season ends and the slack season commences and viceversa.
   (7) There is almost complete absence of acceptance business and discount housed in the Indian money market.
       This is largely due to the fact that there is no true market for bills, either commercial or treasury. Though
       banks discount bills, they have not got into the habit of rediscounting except during emergencies.
   (8) The structure and constituents of Indian money markets being very much different from those of the
       developed money markets like London money market, it is usual to think of the divided into two main sectors
       along the lines of our earlier analysis, within both these two main divisions, quite a high degree of
       specialization has developed including some provision of facilities for the flow of funds between them. It may
       be observed, therefore, that from the pint of view of specialization of functions and organized relationships,
       the Indian money market may be considered to be comparatively well developed.
   (9) During the last thirty years or so, the corporate sector both public and private in India has been growing from
       strength to strength. Not only is their number growing, but so is their size and importance. Many companies
       today are keen to use their short term funds with maximum advantages to the company. This is creating new
       demand for profitable avenues for parking short term funds of the companies.

Defects of the Indian Money Markets

   As a consequence of the establishments of RBI, passing of the Banking Companies Act in 1949 and the
   subsequent amendments, made from time to time, setting up of the State Bank of India nationalization of major
   commercial banks and the expansion of their branches and business, progress of cooperative societies, and the
   measure adopted by the RBI for the regulation and control of different institutions, the Indian money market has
   been strengthened and improved in several respects. However one can notice the following shortcomings of
   Indian money market.

   (1) Absence of integration

                 A basic defect of the Indian money market was the division of the money market into several sections
   with each section being very loosely connected with the other sections. At one time, the different commercial
   banks, cooperative banks and indigenous bankers confined themselves to a particular class of business and
   remained independent in their own sphere. Very often the different sections of the money market showed hostility
   towards one another. Thus the Indian Joint stock banks were jealous and suspicious of the old Imerial Bank of
   India and foreign exchange banks, as they were patronized by the then Imperial Governments of India. The
   organized banking system and unorganized indigenous bankers did not have nay contract between them
   remaining completely aloof from each other. With the emergence of the Reserve Bank of India as a genuine
   central bank of the country since 1935, this defect is being gradually removed. The RBI effectively controls the
   affairs of the organized sector of the Indian money market which has gradually become the more important part of
   the Indian money market. The Commercial and Cooperative banks have come to depend increasingly on the RBI
   for the financial accommodation by way of rediscounting and borrowings facilities provided by the RBI.
   Additionally the central bank also guides the commercial banks in the matter of their lending operations, decides
   their branch opening policy and inspects their books and accounts regularly.

   (2) Existence of unorganized sector:

        The Indian money market is dichotomized into organized and unorganized sectors. The unorganized sector
dominated by the activities of indigenous bankers constitutes a major weakness of the Indian money market because
the indigenous bankers follow their own rules and practices of finance and banking and are not subject to the
regulation and control of the RBI. Many attempts were made by the RBI to bring the indigenous bankers under the
organized market and, thus, under its influence and control. These attempts failed, since indigenous banes as a
whole have not accepted the conditions prescribed by the RBI. To the extent these bankers are outside the organized
market, the RBI’s influence over them is limited.

(3) Diversity in the money interest rates:

          In countries with well developed money markets, the rates of interest prevailing over the entire money
markets will not vary much. But in the case of the Indian money market the rate of interest charged by the various
institutions not only vary but also vary from season to season. For instance the rates of interest charged by the
indigenous bankers or the money lenders do not bear any comparison with the rates of interest charged by joint stock
banks. Highlighting the glaring defect of the Indian money market more than fie decades ago, the Indian Central
Banking Enquiry Committee in 1931 had stated. “The fact that a call rate of ¾ percent, a hundi rate of 3 percent, a
bank rate of 4 percent, a bazaar rate for small traders of 6 2/3 percent and a Calcutta Bazar rate for bills of small
traders of 10 percent can exist simultaneously indicates extraordinary sluggishness of the movement of credit
between various markets”. This divergent interest rates limits the efficiency of the bank rate policy of the RBI.
Immobility of funds from one place to another may be considered as an important reason for this multiplicity of
interests rates. Moreover the money rates of interest also differ between different regions or centres due to the
difficulty of making cheap and quick remittance of funds from one financial centre to others. Although the wide
divergence between interest rate does not exist at present, still the situation cannot be said to be identical with that
found in the developed money market.

(4) Seasonal stringency of funds

         A very striking characteristic feature of the India money market has been the seasonal monetary stringency
and high money rates during the busy season when funds are required to more the crops from the villages and up
country districts to the cities and ports. On the other hand, during the slack seasons accumulation of the idle funds is
experienced. Thus wide fluctuation is noticed in the money rates from one period of the year to another. Before 1935,
the call money rates rose sometimes to 7 to 8 percent in the busy season while in the slack season they fell to as low
as 1 percent to ½ percent. RBI has done a useful job by pumping in funds during busy seasons had reducing them
during slack seasons. Besides the bank rate has noticeably reduced the seasonal fluctuations in interest rates.
However the seasonal fluctuations in the supply of funds in the money market continue till now.

(5) Absence of the bill market

         Finally the reluctance of money lenders and indigenous bankers to shed their non banking business and
come under the control and supervision of the RBI also frustrated the Bank’s plan to create a bill market.
         A well organized bill market is essential for the smooth working of the credit system. It is also necessary for
linking up the various credit agencies ultimately and effectively to the central bank of the country. Thus, to remedy the
defect of the Indian money market, suggestions are often made by various quarters for the establishment of
acceptance houses and discount houses which were instrumental in the development of an organized bill market in
the London Money Market. However it is not practicable in all cases.
         As observed by AFW Plumptre, “The need of developing countries is not for the trapping of financial maturity,
but for institutions much close to the economic and political grass roots. Indeed, with the pressing need to allocate
very scarce capital with highly urgent uses, the establishment and development of financial markets may actually lead
to a diversion and wastage of capital.” In this connection, the setting up of the Discount and Finance House of India
Limited in 1988 has been a step in the right direction. It is hoped that this would go a long way towards the
development of a secondary market in treasury bills, commercial bills and other money market instruments. Similarly
suggestions have also been made from time to time for the development of factoring institutions to which accounts
receivable in respect of which bills cannot be drawn can be sold for a fee. Trade dues will be collected by the
factoring institutions, thus factoring services, if available, can alleviate the difficulties experienced by industrial units,
particularly those in the small scale sector, in collecting payments for he supplies made by them to various
purchasers from both the public and the private sectors. Reacting to this suggestion, the RBI in the early 1990s has
permitted some of the public sector banks to set up factoring subsidiaries.
         From the foregoing description, it is obvious that the Indian money market is not so developed as that of the
Landon/New York money market. However, it has been gradually strengthened upon the various steps taken by the
RBI. The measures taken by the RBI include strengthening of the commercial banking infrastructure, setting up of the
specialized financial institutions, introduction of innovative money market instruments etc., Hence it can be concluded
that the Indian money market is comparatively well developed in terms of the organized relationships and
specialization of functions.
                                                    LESSON – 13


        Before proceeding to discuss the relationship between Banker and Customer, it is essential to know the
precise meaning of the words ‘Banker’ and ‘Customer’.

Meaning of Banker

There are numerous definitions of the words ‘Bank’ and ‘Banker’. But most of them are not satisfactory. Dr. H.C. Hart
has given a typical definition. According to him, “A banker of bank is a person or company carrying on the business of
receiving money s and collecting drafts, for customers subject to the obligation of honouring cheques drawn upon
them from time to time by the customers to the extent of the amounts available in their Current Account”.
        The above definition insists on the following requirements before recognizing a person or institution as a
banker or bank.

    a) Acceptance of money on current account and the collection of cheques and drafts for the customer.
    b) Payment of cheques or orders drawn by customers which are essentially payable on demand. Of course
       these instruments will be honoured to the extent amounts are available in the current account or up to an
       agreed overdraft limit, and
    c) Banking business must be the main business of such person or company. This view was held in Stafford V.
       Henry (1850). In this case one Lebertouche had carried on a very varied business, part of which was at that
       time regarded as banking, but as it was not his main business, it was held that he was not a banker.

    Sir John Paget has given another definition. According to him, oen can be a (banker who does not 1) take deposit
    accounts 2) take current account 3) issue and pay cheques and 4) collect crossed and uncrossed for his
         The frequently used definition of a banker as a dealer in money and credit is not satisfactory, since there are
    many other forms of financial business other than banking which deal in money and credit e.g. money lenders
    deal in money and credit, they may even receive deposits, but do not come under the category of bankers.
    Similarly building societies receive deposits and they also provide credit but they are not banks. In both cases,
    demand deposits against which cheques can be drawn by customers are not kept.

    Definition of a customer

        The term ‘customer’ of a bank is not defined by law. Ordinarily, a person who has an accounts in a bank is
    considered its customer. Banking experts and legal judgments in the past, however, used to qualify this
    statements by laying emphasis on the period for which such account had actually been maintained with the bank.

        In Sir John’s view “to constitute a customer there must be some recognizable course or habit of dealing in the
    nature of regular banking business”. This definition of a customer of a bank lays emphasis on the duration of the
    dealings between the banker and the customers and is, therefore, called the ‘duration theory’. According to this
    view point, a person does not become a customer of the banker on the opening of an account, he must have
    been accustomed to deal with the banker before he is designated as a customer.

        The above mentioned emphasis on the duration of the account is now discarded. Thus in Ladbroke V. Todd
    Justice Bailhache said that the relation of banker and customer begins as soon as the first cehque is paid in and
    accepted for collection, and not merely when it is paid.

        This view was further supported in Commissioners of Taxation B. English, Scottish and Australian Bank Ltd.
    where the Privy Council said that “the word customer signifies a relationship of which duration is not of the
    essence. The contract is not between habitué and newcorner, but between a person for whom the bank
    performs a causal service… and a person who has an account of his own at the bank.
    According to Dr. Hart, “a customer is one who has an account with a banker or for whom a banker habitually
    undertakes to act as such” Supporting this viewpoint, the K Kerela High Court observed:

    “Broadly speaking, a customer is a person who has the habit of resorting to the same place or person to do
    business. So for as banking transactions are concerned he is a person whose money has been accepted on the
    footing that the banker will honour up to the amount standing to his credit. Irrespective of his connection being of
    short or long standing”
Thus, a person who has a bank account in his name and for whom the banker undertakes to provide the facilities
as a banker, is considered to be a customer. It is not essential that the account must have been operated upon
for some time. Even a single deposit in the account will be sufficient to designate a person as customer of the
banker. Though emphasis is not being laid on the habit of dealing with the banker in the past. Such habit my be
expected to be developed and continued in future. In other words. Customer is expected to have regular dealings
with his banker in future.

An important consideration which determines a person’s status as a customer is the nature of his dealings with
the banker. It is evident from the above that his dealing with the banker must be relating to the business of
banking. A banker performs a number of agency functions and renders various public utility services besides
performing essential functions as a banker A person who dose not deal with the banker in regard to the essential
functions of the banker, I e. accepting of deposits and lending of money, but avails of any of the services
rendered by the banker, is not called a customer of the banker. For example, any person without a bank account
in his name my remit money through a bank draft, encash a cheque received by him from others or deposit his
valuables in the safe deposit vaults in the bank or deposit cash in the bank to be credited to the account of the
Life Insurance Corporation or any joint stock company issuing new shares But he will not be called a customer of
the banker as his dealing with the banker are not in regard to the essential functions of the banker. Such dealing
are considered as casual dealings and are not in the nature of banking business.
Thus to constitute a customer the following essential requisites must be fulfilled:

i)      a bank account-savings, current or fixed deposit-must be opened in his name by making necessary
        deposit of money, and
ii)     the dealing between the banker and the customer must be of the nature of banking business.

A customer of a banker need not necessarily be a person. A firm, joint stock company, a society or any separate
legal entity may be a customer. Explanation to newly introduced Section “customer” includes a Government
department and a corporation incorporated by or under any law.
General Relationship Between Banker and Customer

The relationship between a banker and his Customer essentially flows from the contract. It is fundamentally the
relationship of debtor and creditor, the respective positions being determined by the state of the account.
However in relation to other services rendered by banker he is sometimes an agent of the customer, as for
example, in collection of cheques, sale of securities, etc., bailee in relation to the safe custody of valuables; and
trustee when he is entrusted with property to be administered for the benefit of a named beneficiary.

Debtor and Creditor relationship

This concept of debtors and creditor relationship is a departure from the original view that the banker is a mare
depository of the funds of the customer and was enunciated in Foley V. Hill where it was observed that “the
money, when paid into bank ceases altogether to be the money of the principal; it is then the money of the banker
who is bound to return an equivalent by paying a similar sum to that deposited with him when he is asked for it.”

    Normally the customer is the creditor and the banker is the debtor. But when the account is everdrawn the
roles are reversed. However there are certain difference between the ordinary commercial debts and the debts
due from bankers.

i) The creditor must demand payment: In case of ordinary commercial debt the debtor pays the amount on the
specified date or earlier of whenever demanded by the creditor as per the terms of the contract. But in case of a
deposit in the bank, the debtor/baker is not required to repay the amount on his own accord. It is essential that the
depositor (creditor) must make a demand for the payment of the deposit in the proper manner. This difference is
up to he fact that a banker s not an ordinary debtor, he accepts the deposited with an additional obligation to
honour his customer’s cheques. If he returns the deposited amount on his own accord by closing the account,
some of the cheques issued by the depositor might be dishonoured and his reputation might be adversely
affected. Moreover, according to the statutory definition of banking the deposits are repayable in demand or
otherwise. The depositor makes the deposit for his convenience, apart from his motive to earn an income (except
current account). Demand by the creditor is, therefore, essential for the refund of the deposited money. Thus
deposit made by a customer with his banker differs substantially from an ordinary debt.

ii) Proper place and time of demand: The demand by the creditor must be made at the proper place and in
proper time. A commercial bank, having a number of branches, is considered to be one entity, but the depositor
enters into relationship with only that branch where an account is opened in his name. His demand for the
repayment of deposit must be made at the same branch of the bank concerned otherwise the banker is not bound
to honour his commitment. However, the customer may make special arrangement with the banker for the
repayment of the deposited money at some other branch. For example, in case of bank drafts, traveller’s cheques
etc., the branch receiving the money undertakes to repay it at a specified branch or any branch of the bank.

    It is also essential that the demand must be made during banking hours only on a working day of the bank. If
the makes payment after or before the banking hours, he might be held liable for the same.

iii) Demand must be made in proper manner : According to the statutory definition of baking, deposits are
withdrawable by cheques, drafts, order or otherwise. It means that the demand for the refund of money deposited
must be made through a cheque or an order as per the common usage amongst the bankers. In other words, the
demand should not be made verbally or through a telephonic message or in any such manner.

    Bankers as a Trustee: Ordinarily, a banker is a debtor of his customer in respect of the deposits made by
the latter, but in certain circumstances he acts as a trustee also. A trustee holds money or assets and performs
certain functions for the benefits of some other person called the beneficiary. For example, if the customer
deposits securities or other valuables with the banker for safe custody, the latter acts as a trustee of his customer.
The customer continues to be the owner of the valuables deposited with the banker. The legal position of the
banker as a trustee, therefore, differs from that of debtors of his customer. In the former case the money or
documents held by him are not treated as his own and are not available for distribution amongst his general
creditors on case of liquidation.

    The position of a banker as a trustee or as a debtor is determined according to the circumstances of each
case. If he does something in the ordinary course of his business, without any specific direction from the
customer, be acts as a debtor (or creditor). In case of money or bills, etc., deposited with the bank for specific
purposes, the banker’s position will be determined by ascertaining whether the amount was actually debited or
credited to the customer’s account or not. For example, in case of a actually debited or credited to the customer’s
account or not. For example, in case of a cheque sent for collection from another banker, the banker acts as
trustee till the cheque is realized and credited to his customer’s account and thereafter he will be the debtor for
the same amount. If the collecting bank fails before the payment of the cheque is actually received by it form the
paying bank, the money so realized after the failure of the bank will belong to the customer and will not be
available for distribution amongst the general creditors of the bank.

     On the other hand, if a customer instructs his bank to purchase certain securities out of his deposit with the
latter, but the bank fails before making such purchase, the bank will continue to be a debtor of his customer (and
not a trustee) in respect of the amount which was not withdrawn from or debited to his account to carry out his
specific instruction.

The relationship between the banker and his customer as a trustee and beneficiary depends upon the specific
instruction given by the latter to the former regarding the purpose of use of the money or documents entrusted to
the banker. In other words, when a person dealing with a bank delivers money to a intention to create a
relationship of creditor and debtor between him and the bank is presumed, unless this presumption is rebutted.

For example, i) when the money is to paid to a bank with special instructions to retain the same pending further
instructions, or ii) to pay the same to other person who has no account with the bank and the bank accepts the
instruction and holds the money pending instruction from that other person, iii) where instructions are given by the
customer to his banker that a part of the amount lying in his account be forwarded to another bank to meet a bill
to become due and payable by him and the amount is sent by the banker as directed, a trust results and the
presumption which ordinarily arises by reason of payment of money to the bank is rebutted.

    In case the borrower transfer to the banker certain shares in a company as a collateral security and the
transfer is duly registered in the books of the issuing company no trust is created in respect of such shares and
the bank’s position remains that of a pledge rather than a trustee.

   Banker as Agent

        As stated earlier a modern banker performs many functions as the agent of his cusotemr and for his
   convenience. Some of the agency functions are buying and selling securities, collection of cheques, payment of
   bills and periodic payments. In this position the banker and customer relationship is governed by the law relating
   to Principal and Agent. The banker enjoys all the rights of an agent and in turn is subject to all the obligations that
   flow from agency.

   Rights and Duties (Obligations) of Banker

         Arising fro the relationship of a banker and customer the banker has the following rights and duties.

         1.   Banker enjoys a general lien over customers’ securities in his possession.
         2.   He has an implied right to charge a reasonable commission for his services and interest upon loans.
         3.   He has the right of set-off like may other debtor.
         4.   He has the right to appropriate payments as per the rules down in Claytons’ case.
         5.   Banker need not seek out the creditor to make the payment. It is the creditor who should demand

       1. To receive his customers’ money and cheques and other instruments for collection.
       2. To repay the customer’s deposit on the presentation of customer’s mandate known as the cheque.
       3. To maintain secrecy in respect of customer’s account and affairs.
       4. To give a reasonable notice before closing a customer’s account.
Some of the rights and duties are discussed subsequently in detail.

                                                     LESSON – 14

                                            OBLIGATIONS OF A BANKER

         Though the primary relationship between a banker and his customer is that of a debtor and a creditor or vice
versa, the special features of this relationship, impose the following additional obligations on the banker.

        1. Obligation to honour the cheques: The deposits accepted by banker are his liabilities repayable on
demand or otherwise. The banker is therefore, under a statutory obligation to honour his customer’s cheques in the
usual course. Section 31 of the Negotiable Instruments Act. 1881, lays down that:

       “The drawee of a cheque having sufficient funds of the drawer in his hands, properly applicable to the
    payment of such cheque must pay the cheque when duly required to do so and in default of such payments must
    compensate the drawer for any loss or damage caused by such default.

        Thus, the bankers is bound to honour his customer’s cheques provided the following conditions are fulfilled:

        i) There must be sufficient funds of the drawer in the hands of the drawee. By sufficient funds is meant funds
at least equal to the amount of the cheque presented. The funds must be sufficient in the hands of he banker.
Generally, the cheques sent for collection by the customer are not related as cash in the hands of the banker until the
same are realized. The banker credits the amount of such cheques to the account of the customer on their realization.
A banker should, therefore, be given sufficient time to realize the amount of the cheque sent for collection before the
said amount is drawn upon by the customer. If the customer draws a cheque with the remark ‘Effects not cleared’.

         Further, the credit balances in other accounts of the customer at other branches or head office of he bank
need not be taken into account in computing the sufficiency of funds for this purpose. Cheques are generally payable
at the branch where the account of the customer is kept and each branch of a bank of is treated as a district entity for
this purpose.

         It is to be noted that the funds in the hands of drawee banker must be equal to or more than the amount of
the cheque presented for payment. The banker is directed by the drawer to pay a specified sum of money to the
payee ant if such sum is not in the hands of the banker at the time of presentation of the cheque, the latter is under no
obligation to make part payment of the cheque. He would, therefore, be justified in refusing payment of the cheque.

        If the payee of the cheque makes a deposit in the account of the drawer to make up such deficiency and then
presents the cheque for payment, the banker will be justified in making such payment. But the banker should not
disclose to the payee the amount by which the credit balance in the drawer’s account fall sthort of the amount of the
cheque, otherwise he will be liable for damage for disclosing information aobut his customer’s account to a third party.

         ii) The funds must be properly applicable to the payment of the cheque. A customer might be having several
bank accounts in his various capacities. But it is essential that the account on which a cheuqe is drawn must have
sufficient funds. If the customer is having a debit balance in his current account, he cannot draw a cheque on the
basis of his fixed deposit with the banker as the latter is a deposit under a separate agreement for a specific period
and can be withdrawn in the prescribed manner and not through a cheque.

       The banker’s obligation to honour the cheques is further extended if an agreement if reached between the
banker and the customer, either expressly or impliedly, whereby the banker agrees to sanction an overdraft to the

        In such cases the banker’s obligate to honour the customer’s cheques is extended up to the amount of
overdraft sanctioned by him. If the banker subsequently reduces the limit of overdraft or withdraws in altogether, he
must honour the cheques issued by the customer before the notice of such reduction or withdrawal is served upon
him. Sometimes an obligate also emerges out of the past practice followed by the banker. For example, if the banker
has honoured the cheque of a customer on several occasions in the past without sufficient funds and later on
requested the customer to make good the deficiency in his account, an implied arrangement to overdraw the account
is presumed to exist. The banker should not discontinue such practice without giving prior notice to the customer.

        iii) The banker must be required to pay: The banker is bound to honour the cheques only when he id duly
required to pay. This means that the cheque, complete and in order, must be presented before the banker at he
proper time. Ordinarily a period of is months is considered sufficient within which a cheque must be presented for
payment On the expiry of this period the cheque is treated as stale and the banker dishonours the cheque. Similarly,
a post-dated cheque is also dishonoured by the banker because the order of the drawer becomes effective only on
the date given on the cheque.

        iv) There must be no legal bar preventing the payments of such cheques e.g., if a Granishee order is issued
by a court attaching the funds in a particular account, cheques drawn against such accounts must necessarily be

         Garnishee order: Garnishee order is an order from the court obtained by a judgment-creditor attaching the
funds in the hands of a third party due to the judgment debtor. This is subject to the condition that the funds attached
must be actually due from the garnishee, i.e., the third party and in our context, the banker. However an existing debt
through payable at a further date, may be attached. Thus fixed deposits coming under this category can be subject to
attachment. But fixed deposits which can be withdrawn after the customer’s notice cannot be attached. The reason is
simple. In such a case there is no existing debt unless and until the notice is given by the customer.

        Types of orders: There are two types of orders that may be made by a court Garnishee order is only an
interim order and operates as an order freezing debt. No funds are payable by the banker to the court until the order
is made absolute by the court.

        Since the Garnishee order attaches only the existing debt., it is possible for the banker to open new account
for sums deposited subsequently and allow him to draw cheques.

        The following are some of the legal decision affecting garnishee orders:

        1 Where there is joint account in the name of husband and wife, such an account cannot be attached in
favour of husband’s judgments creditor.

        2. Funds paid into the custoemr’s account subsequent to the receipt of the order are not attachable.

        3. The banker immediately, after the order is received, can exercise his right or set-off. (Tyaballe V. Atmarma)

      4. Unclosed cheques previously paid into the customer’s account are not attached unless the banker by
agreement or usage allowed cheques to the drawn against such accounts. (A.L Underwood Ltd. V. Barclays Bank

         5. Partnership accounts cannot be attached unless the order is made against all the partners, or in the name
of the partnership.

        6. Garnhishee orders can attaché trust moneys also, provided the amount is to the customer’s credit. The
reason is that such a money is a debt owing to the customer and as such attachable.

        7. Balances to the credit of customer’s account at branches of the bank in a foreign country cannot be

Bank’s procedure on receipt of order

         1. If the order is served on the bank’s head office, then the branch where the account is held should be
notified for which a reasonable time is always allowed.

        2. The question of attachment does not arise, if the customer’s balance is in debit. Such an order will be
withdrawn and therefore, does not warrant by action.

       3. The garnishee order must state the name of the customer correctly, to enable the baker to identify the
judgment-debtor. Otherwise, the bank is not bound to act upon it.

        4. Customer should be advised of the order and also the banker’s intention to comply with the order.

       5. When the customer is having a large balance and the attachment is for a limited amount far less than the
balance, the banker can transfer the necessary amount (including court costs if any) to a separate account pending
payment to the court and the customer can be allowed to operate the balance in the account. But if the order attaches
all the debts owing to the customer without limit, then his account must be stopped. Even in such a case, if the
amount of the judgment debt and the costs is ascertained, the banker at his discretion can allow the customer an
overdraft on a new account against the surplus balance of the garnished account.

         Liability of the Banker in case of wrongful Dishonour of Cheques: A banker has the statutory obligation
to honour his customer’s cheques unless there are valid reasons for refusing payments of the same. In case be
dishonours a cheque, intentionally or by mistake, he is liable to compensate the customer for the loss suffered by
him. According to Section 31 of the Negotiable Instruments Act, 1881, the banker is liable to compensate the drawer
for any loss or damage caused by the default on his part in dishonouring the cheques without sufficient reason. The
banker thus incurs heavy liability for any mistake or default committed in dishonouring his customers’ cheques.

         Causes of Wrongful Dishoour: Wrongful dishonour of a cheque means a dishonour committed by mistake
of by negligence on the part of the banker or any of its employees. A banker must honour the cheques of the
customer so long as the latter’s account has sufficient funds. If the banker commits a mistake in his account books
which reduces correct balance in the account of the customer and thus a cheque is dishonoured, the banker will be
liable for such wrongful dishonour. For example, if a credit made by a customer is posted to some other account or
debit entry of some body else is posted to the customer’s account, the latter will not show the correct balance.
Similarly, if a post-dated cheque is honoured by the banker before eh date of the cheque and thus the balance in the
customer’s account is reduced, the banker will be liable for wrongful dishonour of a cheque subsequently presented
for payment.

         The banker will, however, not be responsible for wrongful dishonour if the customer makes a deposit or a
credit is received by main in order to make the funds sufficient after the cheque has been dishnonoured by the bank.
Similarly, if the banker has not been furnished with the names and specimen signature of the persons who have
been authorized to sign cheques on behalf of a person, company or institution, he can justifiably dishonour the
cheques signed by them.

         It was stated earlier that when a banker allows the customer to open a current account the stipulation is that
he should not injure the customer’s credit by refusing the payment of cheques drawn against such account expect on
reasonable and proper grounds. From this it naturally follows that when a customer’s credit is injured the banker has
to compensate by paying damages. This has been stated in Section 31 of the Negotiable Instruments Act. 1881 (ref.
Obligation to honour customer’s mandate:). This damage is not limited to the actual loss suffered by the customer and
extends to loss of credit or business reputation which entitles a customer to claim heavy damages. After an analysis
of the various decisions on this point the following rules emerge.

         1. The amount of damages will be more in the case of a trader customer and such damages are presumed
without proof. Damages may be substantial or exemplary. In the case of non-trading customers substantial damages
will be awarded only if it is proved as special damages. Gibbon V. West minister Bank Limited (1930).

        In this case the plaintiff was a customer of the defendant bank and she paid a certain sum of money to her
account. Which was by mistake credited to a wrong accunt by the banker. Later on a cheque issued by her was
dishonoured because of this mistake. Upon the dishonour she filed a suit claiming substantial damages. But it was
held that as the plaintiff was a non-trader, who had not proved any special damager, she was entitled to nominal
damages only and was awarded just 40 shillings. The same view was held in an Indian case New Central Hall V.
United Commercial Bank Ltd.

        2. The maxim is “smaller the cheque, greater the damage”. It must not be assumed that special damages will
be awarded only if the amount of the cheque is very large. Courts have invariably awarded more damages in the case
of cheques involving small amounts. The reason is simple. Customer suffers more loss of reputation when a cheque
for a small amount is dishonoured. Davidson. V. Barclays Limited.

        In this case the plaintiff, a book maker drew a cheque for 42-15-8. It so happened that the banker paid
previously a cheque which the plaintiff had counter manded. On the account the cheque in question was returned
because of insufficient funds on a suit by the plaintiff for damagers the court awarded a sum of $250.

        3. The amount of damages will depend upon the history of the customer’s account. If the customer already
has to his discredit one or two instances of his cheques being dishnonoured due to insufficient funds, the court may
award nominal damages only.

         Any additional or alternative action for the tort or libel may be brought under certain circumstances. For
example if the cheque is marked “Refer to drawer”, the general view is that the words “Refer to drawer” merely inform
the holder that he must approach the drawer as to the reason for the dishonour of the cheque. The old view was in
case of improper dishonour with such an answer there would be breach of contract but not libel. Libel is sometimes
more expensive for the banker than a breach of contract because damages are awarded without the need to prove a
specific loss. Whereas if it is simply a breach of contract; such loss will have to be proved.

          But in Pyke V. Hibernian Bank Ltd., where certain cheques were wrongly dishonoured by the drawee bank
being marked “Refer to drawer”, it was held that the drawer of the cheque was entitled to damages of $1 for breach of
contract and $ 400 for libel. The court was of the view that the words refer to drawer meaning to “no funds” amounted
to libel. In Jayson V. Midland Bank (1968) the court justified the return of the plaintiff cheque marked “Refer to
drawer”. But the court held that the words would have been libelous if funds had been available.

                                                       LESSON – 15

                                           OBLIGATIONS OF A BANKER II

          The relationship between a banker and his customer if confidential even though the duty of secrecy is not
attached to the ordinary relationship of debtor and creditor. It is one of the implied terms of the contract that the
banker must not divulge the customer’s financial position or state of his account and affairs except in accordance with
law or practice or usages customary among banks. In the case of nationalized banks, under Sections 13 of the
banking Companies (Acquisition and Transfer of Undertakings) Act, 1970, every director, member of a local board or
a committee, or auditor, adviser or other employee before entering upon his duties is required to make a declaration
of fidelity and secrecy in the in the forms set out in the Third Schedule to the Act. Similarly, all other banks cal open
every member of their respective staff to sign what is known as a ‘Sectecy Pledge’ relating to their customer’s
business transacted in the course of their duties. In fact, secrecy is a jealously guarded tradition of bankers.

          A banker’s duty of secrecy is a legal one and arises out of the contractual relationship with the customer from
the moment he opens the account and, in the opinion of Sir John Paget, does not end even with the closing of the
customer’s affairs is essential for the protection of his private and business interests. The customer nay enforce this
duty by seeking an injunction from the court to restrain the bank from disclosing information about his account or
affairs to any person whom he has not authorized to receive it. If the bank has already disclosed such information, the
customer may sue it for breach of contract and recover damages for the loss he has sustained as a result of improper

        The guiding case on this subject is Tournier V. National and Union Bank of England (1924) where the Court
of Appeal held that the banker’s duty of secrecy is not absolute but qualified since there are occasions on which a
banker if justified to make the disclosure.

        In this case, T. a customer of the bank, who was allowed to overdraw the account by a small amount without
previous arrangements, agreed to repay it at_1 per week. On his failure to keep to the arrangement, the bank
manager telephoned to his workplace and, being unable to speak to T, discussed T’s banking arrangements with his
employer mentioning also that T was betting. At the end of his probationary period T lost the job. T claimed that the
bank was liable for breach of secrecy and this was upheld by the Court of Appeal.

        In this case, the Court classified the qualifications under four heads:

        a. where disclosure is under compulsion by law;

        b. Where there is a public duty to disclose;

        c. Where the interests of the bank require disclosure; and

        d. where the disclosure is made by express or implied consent of the customers.

These conditions are examined below:

        1. Disclosure of Information Required by Law: A banker is under a statutory obligation to disclose the
information relating to his customer’s account when the law specifically requires him to do so. The banker would,
therefore, be justified in disclosing information to meet the following statutory requirements:

        i) Under the Income-tax Act, 1961: According to Section 131, the income-tax authorities possess the same
powers as are vested in a Court under the Code of Civil Procedure, 1908, for enforcing the attendance of any person
including any officer of a banking company and examining on oath and compelling the production of books of
accounts and other documents and issuing commissions. Section 133 empowers the income-tax authorities to require
any person, including a banking company or any officer thereof, to furnish information in relation to such points or
matter, or to furnish statements of accounts and affairs giving information in relation to such points on matters, as in
the opinion of the income-tax authorities are thus authorized to call for necessary information from the banker for the
purpose of assessment of the bank’s customers.

         Section 285 of the Income-tax Act, 1961, requires the banks to furnish to the Income-tax Officers the names
and address of all persons to whom they have paid interest exceeding Rs. 400 mentioning the actual amount of
interest paid by them.
         ii) Under the Companies Act, 1956: When the Central Governments appoints an Inspector to investigate the
affairs of nay joint stock company under Section 235 or 237 of the Companies Act. 1956, it shall be the duty of all
officers and other employees and agent (including the bankers) of the company to-

        a. produce all the books and papers of, or relating to, the company, which are in their custody or power, and

       b. otherwise to give to the Inspector all assistance in connection with the investigation which they are
reasonably able to give (Section 240).

       Thus the banker is under an obligation to disclose all information regarding the company but not of any other
customer for the purpose of such investigation (Section 251).

         iii) By order of the Court under the Banker’s Books Evidence Act, 1891: When the Court order the
banker to disclose information relating to a customer’s account the banker is bound to do so. In order to avoid the
inconvenience likely to be caused to the bankers from attending the Courts and producing their account books as
evidence, the Banker’s books are to be treated as sufficient evidience and production of the books in the Courts
cannot be forced upon the bankers. According to Section 4 of the Act, “a certified copy of nay entry in a banker’s
books shall in all legal proceedings be received as prima facie evidence of the existence of such entry and shall be
admitted as evidence of the matters, transactions and accounts therein recorded in every case where, and to the
same extent, as the original entry itself is not by law admissible, but not further or otherwise”. Thus if a banker is not a
party to a suit, certified copy of the entries in his books will be sufficient evidence. The Court is also empowered to
allow any party to legal proceedings to inspect or copy from the books of the banker for the purpose os such

         iv) Under the Reserve Bank of India Act, 1934: The Reserve Bank of India collects credit information from
the banking companies and also furnishes consolidated credit information to any banking company. Every banking
company is under a statutory obligation under Section 45-B of the Reserve Bank of India, Act 1934, to furnish such
credit information to the Reserve Bank. The Act, however, provides that the credit information supplied by the
Reserve Bank to the banking companies shall be kept confidential.

         After the enactment of the Reserve Bank of India (amendment) Act, 1974, the banks are granted statutory
protection to exchange freely credit information mutually among themselves.

        v. Under the Banking Regulation Act, 1949: Under Section 26, every banking company is required to
submit a return annually of all such accounts in India which have not been operated upon for 10 years. Banks are
required to give particulars of the deposits standing to the credit of each such account.

       vi) Under the Gift Tax Act, 1958: Section 36 of the Gift Tax Act, 1958 confers on the Gift Tax authorities
powers similar to those conferred on Income Tax authorities under Section 131 of the Income Tax Act.

        vii) Disclosure to Police: Under Section 94(3) of the Criminal Procedure Code, the banker is not exempted
from production the account books before the police. The police officers conducting an investigation may also inspect
the banker’s books for the purpose of such investigation (Section 5, Banker’s Books Evidence Act).

        viii) Under the Foreign Exchange Regulation Act, 1973: Banking companies dealing in foreign exchange
business are designated as ‘authorised dealers’ in foreign exchange. Section 43 of this Act empowers the officer of
the Directorate of Enforcement and the Reserve Bank to inspect the books and accounts and other documents of any
authorized dealer and also to examine on oath such dealer or its director or officials in relation to its business.

        ix. Under the Industrial Development Bank of India Act, 1964: After the insertion of sub-section 1A in
Section 29 of this Act in 1975, the Industrial Development Bank of India is authorized to collect from or furnish to the
Central Government, the State Bank, any subsidiary bank, nationalized bank or other scheduled bank, State Co-
operative Bank, State Financial Corporation credit information or other information as it may consider useful for the
purpose of efficient discharge of its functions. The term ‘credit information’ shall have the same meanings as under
the Reserve Bank of India Act, 1934.

        2. Duty to the public to disclose: Banker may justifiably disclose any information relating to his customer’s
account when it is his duty to the public to disclose such information. In practice this qualification has remained vague
and placed the banks in difficult situations. The Banking Commission, therefore, recommended a statutory provision
clarifying the circumstances when banks should disclose in public interest information relating to the affairs of their
customers by enumerating some specific cases cited below:

       a. When a bank is asked for information by a government official concerning the commission of a crime and
the bank ahs reasonable cause to believe that a crime has been committed and that the information in the bank’s
possession may lead to the apprehension of the culprit.

        b. Where the bank considers that the customer is involved iactivities prejudicial to the interests of the country.

        c. Where the bank’s books reveal that the customer is contravening the provisions of any law.

         3. Disclosure in his own interest: Where the banker discloses the state of the account of a customer in his
own interest, as for example when the wants to recover the money due fro the customer, such disclosure is justified.
Similarly when a debt due fro a customer is guaranteed by another person the banker can disclose the state of the
account to the guarantor with a view to recover the amount due to his from such a customer.

         A leading case on this point, i.e., disclosure in his own interest is Sunderland V. Barclays Bank Ltd. In this
case the customer, a woman issued a cheque to her dressmaker. The cheque was dishonored because of insufficient
funds. The bankers did not wish to allow any overdraft because they knew of the customer’s book making
transactions. The customer protested about the dishonour to her husband, a doctor by profession, who advised her to
take up the matter with the bank. She did so on phone and after a while the husband interrupted the conversation to
add his own protest. The bankers then disclosed to him that cheques had previously been drawn by her in favour of
bookmakers which led to a suit for damages against the bank for breach of duty. The bank contended that the
conversation with the husband was a continuation of that with wife and that they had her implied consent to the
disclosure. This was denied by the customer. But the Judge held that on the facts the banks must succeed, the
disclosure being in their interest, coming under the third qualification in the Tournier case.

         4. With Express or Implied Consent of the Customer: The banker will be justified in disclosing any
information relating to his customer’s account with the latter’s consent. In fact the implied term of the contract
between the banker and his customer is that the former enters into qualified obligation with the latter to abstain from
disclosing information as to his affairs without his consent. The consent of the customer may be express or implied.
Express consent exists in case the customer directs the banker in writing to intimate the balance in his account or any
other information to his agent, employee or consultant The banker would be justified in furnishing to such person only
the required information and no more.

        It is to be noted that the banker must be very careful in disclosing the required information to the customer or
his authorized representative. For example, if an oral enquiry is made at the counter, the bank employee should not
speak in louder voice so as to be heard by other customers. Similarly, the passbook must be sent to the customer
through the messenger in a closed cover. A banker generally does not disclose such information to the customer over
the telephone unless he can recognize the voice of his customer otherwise he bears the risk inherent in such

         In certain circumstances, the implied consent of the customer permits the banker to disclose necessary
information. For example, if the banker sanctions a loan to a customer on the guarantee of a third person and the
latter asks the banker certain questions relating to the customer’s account, the banker is authorized to do so because
by furnishing the name of the guarantor, the customer is presumed to have given his implied consent for such
disclosure. The banker should give the relevant information correctly and in good faith.

        Similarly, if the customer furnished the name of the banker to a third party for the purpose of a trade
reference, not only an express consent of the customer exists for the disclosure of relevant information but he banker
is banker is directed to do so, the non-compliance of which will adversely affect the reputation of the customer.

       Implied consent should not be taken for granted in all cases even where the customer and the enquirer
happen to be very closely related. For example, the banker should not disclose the state of a lady’s account to her
husband without the express consent of the customer.

Banker’s Opinions

       It is a well established practice of banks to answer status enquires addressed to them by other banks (the
only medium recognized by them) with regard to the financial position and business integrity of their customers. This
practice is of mutual business advantage to banks and the business community in making credit facilities available to
them by banks. Banks now also respond to status enquires about the customers from certain Government
departments for securing supply contracts from them.

         The legal implication of this practice should be of interest to banks for if the banker’s report is too favourable,
he may have to fact an action for misrepresentation or negligence brought about by the enquirer, and if he speaks too
unfavourably, there may be action for libel brought by the customer. However, the customer might have even a cause
for complaint if an answer to an enquiry was refused since unwillingness to speak might be construed as derogatory
to the customer.

        Bankers have either express or implied consent of their customers to answer status enquiries. It is considered
that when a customer open an account, it has by implication, authorized the bank to follow the routine practice of
responding to status enquiries received from other banks. It is, therefore, not necessary that the banker should not
reply to an enquiry without the customer’s agreement. Frequently, customers give their banker’s name as a
reference-this is an express consent-but a large number of enquiries are made which are not at the instance of the

The General Rule of Law

         A banker should exercise great care in answering all status enquiries and ensure that he is not negligent in
this regard which is the only duty incumbent on a banker.

Golden Rule

        The golden rule in answering status enquiries is to reply in general terms and allow the enquirer to draw
conclusions by inference. For this purpose, the banker should confine himself to general statement and should not
disclose the actual state of the account unless specially authorized by he customer to do so. Secondly, he should see
that the confines his answers to facts within his knowledge or as disclosed by the account and does not base his
opinions on the rumours that may be afloat regarding credit of his customers. Thirdly, he is not bound to make
enquiries outside as to the solvency or otherwise of the customer about whom an enquiry is made. Finally, he must
take care nto to furnish information which is false.

        The only duty of the banker in such a case is that of “common honesty”, which in more precise terms means
that he must not be fraudulent. Any misrepresentation as to the customer’s financial position which has been made
innocently will not be actionable, and the enquirer can sue the banker only if it can be shown that there was
negligence in dealing with the enquiry. To quote Lord Wrenbury in Banbury V. Bank of Montreal (1918), “Innocent
misrepresentation is not the cause of action, but evidence of negligence which is the cause of action”. It may be
stated here that in the normal way there is no contractual relationship between a banker and the customer of another
bank and, therefore, there is no contractual duty and no ground for nay action based on negligence. Each case,
however, will depend upon the particular facts.

        Accordingly, so long as the banker answers honestly from the knowledge of his customer’s affairs, he cannot
be held responsible for any loss the enquirer may sustain in his dealing with the customer. In answering the enquiry,
the banker, as has been stated before, need not go out of his way to obtain additional information from other sources.
Where an affirmative answer cannot be given the reply must be couched discreetly, leaving to the enquirer to draw
his conclusions very largely by inference. The principle a banker should always bear in mind is that he must not write
anything that might be construed derogatory.

Risks of Unwarranted and Unjustifiable Disclosure:

        The obligation of the banker to keep secrecy of his customer’s accounts-except in circumstances noted
above-continue even after the account is closed. If a banker discloses information unjustifiably, he shall be liable to
his customer and the third party as follows:

a. Liability to the customer: The customer may sue the banker for the damages suffered by him as a result of such
disclosure. Substantial amount may be claimed if the customer has suffered material damages.
        Such damages may be suffered as a result of unjustifiable disclosure of any information or extremely
unfavorable opinion about the customer being expressed by he banker.

b. Liability to the third parties: The banker is responsible to the third parties also to whom such information is given,
if -

        i) the banker furnishes such information with the knowledge that it is false and

        ii) such party relies on the information and suffers losses.

        Such third party require the banker to compensate him for he losses suffered by him relying on such
information. But the banker shall be liable only if it is proved that he furnished the wrong or exaggerated information
deliberately and intentionally. Thus he will be liable to the third party on the charge of fraud but not for innocent
misrepresentation. Mere negligence on his part will not make him liable to a third party.

         This point was very clearly decided by the Houses of Lords in Hedley Byrne and Co. V Heller and Partners
Ltd (1964). In this case the banker of a company in reply to an enquire from a firm of advertising agents, gave his
opinion as follows: “The company was a respectably constituted company, considered good for its ordinary business
engagements”. The banker also added that the figure of $100,000 (mentioned by the enquirer) was larger than they
were accustomed to see. The banker also stated that the opinion was given without responsibility on the part of the
answering banks or its officials. The company subsequently went into liquidation and the advertising firm suffered a
loss of $17,000 and sued the company’s banker for the recovery of this amount on the ground that the replies were
give negligently and in breach of duty to exercise care in giving them.

         The Trial Court held that trough the banker was negligent in his assessment of the position of the company
but dismissed the claim on the ground that the banker owed no duty of care to the advertising firm. The House of
Lords upheld this decision. Lord Reid stated that in general an innocent and negligent misrepresentation gives by
itself no cause of action and that there must be something more than mere misstatement in order to fasten liability on
the person making it. Lord Morris observed that the banker, to whom the reference was made, was not expected to
make a detailed inquiry and produce a well-balanced report. All that was expected was that he should answer
honestly the question put to him from what he knew from the books and accounts before him.

The general conclusions of the Court can be summarized as follows:
       1. A banker answering a reference form another banker on behalf of the latter’s constituent owes a duty of
           honesty to the said constituent.
       2. If a banker gives a reference in the form of a brief expression on opinion in regard to credit worthiness, he
           does not accept and there is not expected of him any higher duty than that of giving an honest answer.
       3. If the banker stipulates in his reply that it is without responsibility, he cannot be held liable for negligence
           in respect of the reference.

Practical Consideration Regarding Disclosure:
         The risk of unjustifiable or inadvertent disclosure on the part of the staff in their daily working is always
present and the grave consequences resulting from breach of the banker’s duty of secrecy should be brought home
to them. For example, if the holder of a cheque for Rs. 1,000 is informed personally by any bank official that there is
insufficient balance by, say, Rs. 50 in the drawer’s account and if the holder himself pays in the differences so that he
losses Rs. 50 ro so for the sake of Rs. 950. an action would lie against the bank. That would be unjustifiable
disclosure and might also constitute a fraud on other creditors of the customers, as was held in Foster V. Bank of
London (1862).

         Similarly, if on enquiry form the customer, the ladger-keeper, shouted across the counter his debit balance
and hearing this the customer’s chief creditor, who happens to be present in the banking hall, stops further credit to
him, this might afford a reasonable ground for action against the bank.

         With a view to eliminating the risk of unlawful disclosure, banks should be well advised to observe the
following safeguards:

         i) If there is any doubt whether the disclosure would be protected by the exceptions’ the customer’s authority
to disclose should be obtained.

        ii) When a customer enquires his balance or wants any information regarding the state of his account on
telephone, the banker should always check his credentials before divulging the information. If the customer’s voice
cannot be rebognised on telephone, the banker should, instead of rejecting the rejecting the request outright, try to
satisfy himself about the proerp identity of the enquirer by other means such as enquirey from him about the
approximate balance in his account, or the amount of recent standing orders or items paid in during the past week or
so. It is not very sensible to ask for the account number or for debits of recent cheques;m if it is thief with the
customer’s cheque book at the other end of the phone, he will be able to give this information and the banker will then
innocently tell him the balance of the account so that he knows how much to draw out on a forged cheque.

       iii) Information should be given ot the customer’s agents or messenger only if the custoerm has givebn his
express consent to the bank in this regard. If the information is to be passed on to the custoeemr through his
messenger, it must always be sent in a closed cover.

        iv) There shold be not objection to pass on the information where it is obvious that there is implied authority of
the customer as, for example, the statement of account of a company customer may be delivered to its secretary on
his request.

                                                      LESSON – 16

                                                RIGHTS OF A BANKER

1. General Lien

         A Lien is the right to retain the property belonging to a debtor until ha has discharged the debt due to the
retainer of the property. A lien is merely a right to retain and is lost when possession is lost. A lien may be either a)
particular or b) general line. A particular lien arises from the particular transaction connected with the property subject
to the lien; a general lien arises not merely out of the particular transaction, but for the general dealing between the
two parties in respect of other transactions of similar character.

        Particular lien is enjoyed by craftsmen like Tailors and Goldsmiths and Bailess like repairers and Public
Carriers. For example a goldsmiths can retain the jewel till the charges are paid. In both cases the right of lien is not
available for any other sums due.

         Bankers and Factors enjoy General Lien. Under Section 171 of the Indian Contract Act, 1881, bankers, in the
absence of an agreement to the contrary, retain as a security for a general balance of account nay goods and
securities banked to them. It extends to all securities placed in his hands as a banker, by his customer which is not
specifically appropriated.

      The leading case on this subject is Brandao V. Barnett. In this case the banker’s lien was described by Lord
Campbell as follows:

         “Bankers most undoubtedly have a general lien on al securities deposited with them, as bankers, by a
customer unless there be an express contract or circumstances that show an implied contract inconsistent with the

Special Features of a Banker’s Right of General Lien:

        i) The banker possesses the right of general lien on all the goods and securities entrusted to him capacity as
a banker and in the absence of a contract inconsistent with the right of line. Thus he cannot exercise his right of
general lien if -

        a) the goods and securities have been entrusted to the banker as a trustee or an agent of the customer, and

        b) a contract-express or implied-exists between the customer and the banker which is inconsistent with the
banker’s right of general lien. In other words, if the goods or securities are entrusted for some specific purpose, the
banker cannot have a lien over them. These exceptional cases are discussed later on.

         ii) A banker’s lien is tantamount ot an implied pledge: As noted aboe the right of lien does not confer on the
creditor the right of sale but only the right to retain the goods till the loan is repaid. In case of pledge the creditor
enjoys the right of sale. A banker’s right of lien is more than a general lien. It confers upon him the power to sell the
goods and securities in case of default by the customer. Such right of lien thus resembles a pledge and is usually
called an “implied pledge”. The banker thus enjoys the privileges of a pledge and can dispose of the securities after
giving proper notice to the customer.

        iii) The right of lien is conferred upon the banker by the Indian Contract Act. No separate agreement of
contract is, therefore, necessary for this purpose. However, to be on the safe side, the banker takes a letter of lien
from the customer mentioning that the goods are entrusted to the banker as security for a loan-existing or future-
taken from the banker and that the latter can exercise his right of lien over them. The banker is also authorized to sell
the goods in case of default on the part of the customer. The latter thus spells out the object of entrusting the goods to
the banker so that the same may not be denied by the customer later on.

        iv) The tight of lien can be exercised on goods or other securities standing in the name of the burrower only
and not jointly with others. For example, in case the securities are held in the joint names of two or more persons the
banker cannot exercise his right of general lien in respect of a debt due from a single person.

        v) The banker can exercise his right of lien on the securities remaining in his possession after the loan, for
which they were lodged, is repaid by the customer, if no contract to the contrary exists. In such cases it is an implied
presumption that the customer has re-offered the same securities as a cover for any other advance outstanding on
that date or taken subsequently. The banker is also entitled to exercise the right of general lien in respect of the
customer’s obligation as a surety and to retain the security offered by him for a loan obtained by him for his personal
use and which has been repaid.

         In Stephen, Manager North Malabar Gramin Bank V. Chandra Mohan and State of Kerala, the loan
agreement authorized the bank to treat the ornaments not only as a security for that loan transaction, but also for any
other transactions or liability existing or to be incurred in future. As the liability of he surety is joint and several with
that of the principal debtor, such liability also came within the ambit of the above provision of the agreement.

Cases where the Banker cannot Exercise His Right of Lien:
         1. In the case of securities deposited with the banker for safe custody only, the banker is acting merely as a
bailee, and has no lien over such articles.

       2. In the case of funds and securities specifically appropriated, the banker cannot exercise his right of lien
because there is an express contract inconsistent with the lien.

        3. A general lien cannot arises in respect of property of a customer pledged as security for a particular debt.

        4. The banker cannot exercise his right of lien in respect of property coming into his hands by mistake or
which is placed in his hands to cover an advances that is not granted (Lucas V. Dorren).

        5. No lien arises until the due date in respect of an advance of a specific amount made for a definite period.

        6. No lien arises in case the credit and liability do not exist in the same right. Thus, the banker cannot
exercise his right of lien over the securities or funds of a parner in respect of a debt due from the firm.

        7. The banker cannot exercise his right of lien in respect of a separate account maintained by a customer
which is known to the banker as a Trust Account.

        8. No lien arises over properties on which the customer has no title.

        9. Right of General Lien becomes that of Particular Lien.

        Banker’s right of general lien is displaced by circumstances which show an implied agreement inconsistent
with the rights of general lien. In Vijay Kumar Vs. M/s Jullundur Body Builders Delhi, and Others (A.I.R. 1981, Delhi
126), the Syndicate Bank furnished a bank guarantee for Rs. 90,000 on behalf of its customer. The customer
deposited with it as security two fixed deposit receipts, duly discharged, with a covering latter stating that the said
deposits would remain with the bank discharged, with a covering letter stating that the said deposit would remain with
the bank so long as any amount was due to the Bank from the customer.

        Bank made an entry on the reserve of the Receipt as “Lien to BG 11/80”. When the bank guarantee was
discharged, the bank claimed is right of general lien on the fixed deposit receipt, which was opposed on the ground
that the entry on the reverse of the letter resulted in the right of a particular lien, i.e., only in respect of bank

          The Delhi High Court rejected the claim of the bank and held that the letter of the customer was on the usual
printed form while “the words written by the officer of the bank on the reverse of the deposit receipt were specific and
explicit. They are the controlling words, which unambiguously tell us what was in the minds of the parties at the time.
Thus the written word will prevail over the printed word.” The right of the banker was deemed that of particular lien
rather than of general lien.

Right to Set-off

         The right of set-of is a statutory right which enables a debtor to take into account a debt owed to him by a
creditor, before the latter could recover the debt due to him from the debtor. In other words, the mutual claims of
debtor and creditor are adjusted totether and only the remainder amount is payable by the debtor. A banker, like other
debtors, possesses this right of set-off which enables him to combine two accounts in the name of the same customer
and to adjust the debit balance in one account with the credit balance in the other. For example, A ha taken an
overdraft from his banker to the extent of Rs. 5,000 and he has a credit balance to the extent of Rs. 2,000 in his
savings bank account, the banker can combine both of these accounts and claim the remainder amount of Rs. 3,000
only. This right of set-off can be exercised by the banker if there is no agreement-express or implied-contrary to his
right and after a notice is served on the customer intimating the latter about the former’s intention exercise the right of
set-off. To be on the safer side, the banker takes a letter of set-off from the customer authorizing the banker to
exercise the right of set-off without giving him any notice.

Conditions of Set-off:

       The right to combine accounts to exercise the right of set-off is hedged with qualifications, as noted before,
and demands close study.

        Separate Accounts of Same Customer: The separation of accounts such “No. 1 A/C”, No. 2 A/C” and
accounts at different branches of the same bank does not of itself deprive the banker of the rights of set-off. Such
separation is prima facie for the sake of convenience and it is the balance of he combined accounts which forms the

         A banker has a right of set-off as between the current and fixed deposit accounts of a customer. This rights of
set-off exists whether the banker does or does nto hold the relative deposit receipt, and can be exercised although
the customer after drawing the cheque may have become insolvent, and since the receipt is not negotiable or even
transferable, this right of set-off is not defeated should the depositor have transferred his deposit receipt to a holder
who takes it in good faith and for value.

        Suppose a customer has a private account and also other accounts in his name designated as follows:
              a. Estate Account
              b. Executor of C deceased
              c. Treasurer of the D School
              d. Treasurer of the E Friendly Society
              e. Annual Function Account.

        If the customer overdraws nay of the accounts (a) to (e), it is considered that he is personally liable for such
overdrafts and that the bank would have a right of set-off against the credit balance on his private account, the reason
being that all the accounts are in the customer’s name. it does not follow that the bank (except in the case of Estate
Account, if the ‘estate’ is the customer’s own) has a corresponding right to set off credit balances on some of the
designated accounts against overdraft on others of them, or on the private account. In the case of E Friendly Society
the account should not have been opened in the name of an individual, but should have been opened in the name of
the Society.

Debts Due in Different Rights: These debts cannot be set off on the principle that on man’s money cannot be used
to pay off other man’s debts, as shown in the following cases:

         i) Separate and Joint Debts: Unless the parties have agreed to be jointly and severally liable for a joint debt,
to right of set-off exists between customer’s private account and any joint account in which his name appears, as they
are not the debt due as between the same parties and in the same rights. Similarly, the joint credit balance cannot be
set off against debit in either of the sole names unless they have agreed with the bank that it may. But if it is shown
that a joint account through kept in two names is really in trust for one of them, the amount due under one account
can be set off against the amount due on another account.

         Under the law prevailing in India, a deposit by a Hindu husband in the name of himself and his wife payable to
either or survivor must, in the absence of evidence to the contrary, be presumed to belng to the husband. Thus, a
credit balance in an account in the joint names of husband and wife can be set off against an overdraft in the sole
name of the husband.

         ii) Minor’s Accounts and Private Account of Guardian: An account of a party as guardian for a minor is
not to be treated in the same right as his own account with the banker and so the right of set-off is not available.

         iii) A Partner’s Private Account and the Firm’s Account: It is an established rule that banker cannot set off
the credit balance on a partner’s private account against a debt due on the firm’s account and vice versa as these are
accounts not in the same right. But if the partners are jointly and severally responsible to the bank for any debt on the
firm’s account (as in usually the case), the banker would have the right to set off any credit balance on the partner’s
separate account against a debt on the firm’s account. In such a case, a reasonable notice should first be given
unless an authority to combine the accounts is held. In case of a sole trader, the account in his personal name and
that in the firm’s name are deemed to be in the same right and hence the right of set-off can be exercised in these

           iv) Personal Accounts and Accounts in a Fiduciary Capacity: The money held by a person in his fiduciary
capacity, i.e., as executor, administrator or trustee, cannot be set off against his private debt as the same are not held
n the same capacity. But if the fiduciary account is overdrawn he is personally liable for the overdraft and his private
credit balance can be set off against it, unless the terms on which the overdraft was arranged is inconsistent with
such a right of set-off. A customer who purchased a draft in his own name on behalf of a principle and refused to
endorse was a trustee in respect of the draft amount and the banker could not set off the trust money against the
liability of the customer in his private account. Similarly, the balance held in the client’s account of an advocate is held
by him as a trustee and is not to be treated to be held in the same capacity in which the amount is held in his private
account. Again, a credit balance on an account in the name of executor as, for example, “A.B. Executor of X.Y.
Deceased” is not good set-off against a debit balance standing on the account of X.Y. deceased.

Debts Due and Further or Contingent Debts

        The right of set-off can be exercised in respect of debts due and not in respect of future or contingent debts. A
debt not yet due cannot be set off against a debt already due.

          For example, a banker cannot set-off a debt due to him upon a loan account repayable on demand or at a
certain future date against credit balance on current account for until demand or arrival of the due date the loan is not
due for payment. Similarly, the banker has no right to set off a deposit balance against the depositor’s contingent
liability on current discounted bills, but in the event of customer’s insolvency, the banker has a right to set off credit
balance on the account against the contingent liability on any bill he has discounted for the customer. If the customer
has a deposit account and is also a party to bill lying unpaid, the banker can refuse payment of the deposit to him and
apply the amount or so much as is required, to the depositor’s matured obligation held by the bank.

Sale of Securities

         Where a borrower has lodged securities as cover for an advance and if the banker applied the amount in
satisfaction of the amount due and is left with a surplus, ha has a right of set-off against the surplus for an overdraft
on another account even though maintained at another branch of the same bank.

Stopped Accounts

         In the case of ‘stopped’ accounts, the right of set-off becomes available to a banker automatically. An
account is ‘stopped’ when a customer dies or is declared insolvent or insane, or by the service of a garnishee order.
In such an event all the accounts of the customer in the same right must a immediately combined in order to ascertain
how much is due to or from the customer’s estate. The same steps will be taken in the case of a failure of a firm or
liquidation of a company. The accounts of a deceased customer are broken by his death and all the accounts may be
combined, setting off any debt balances, before paving over to the legal personal representative of the deceased.

        Where a garnishee order is served in respect of a customer having more than one account in his own right,
the banker has the right to first exercise the right of set-off before accounting to the judgment creditor.

        If the trustee in bankruptcy of a customer, who has money on deposit and also an overdraft account, claims,
by presenting the deposit receipt of pass book, to have the amount of deposit paid to him leaving the bank to prove
the whole amount of the overdraft, the banker can refuse to oblige the trustee and set off the deposit against the

Deceased Customer’s Overdraft Account and the Account of Executors or Administrators

         On the death of a customer having an overdrawn account, the bank cannot debit his executors or
administrator’s account without their authority even though the grant of probate or administration is produced because
they cannot be made personally liable for the deceased’s debt without their consent. Executors or administrators are
personally (but jointly, not severally) liable for money which they borrow, and for other debts which they incur, in the
course of their administering their testator’s or in estate’s estate, and their creditors are not the creditors of the estate
(Farhall V. Frhall 1971). Even if they have an account in their joint names with a balance sufficient to discharge the

debt, there is no right of set-off between that account and deceased’s. The money in the hands of the personal
representative is available for distribution amongst all the creditors of the estate.

         If the deceased’s account was overdrawn at the time of his death, the bank may continue to hold the
securities, if any, deposited by the deceased against his overdraft, but if the executors or administrators take the
overdraft into their own names (which they are not obliged to do), it becomes a personal liability of theirs, and ceases
to be secured by securities deposited by the deceased, unless they are recharged by them to secure such liabilities. It
is the practice of banks to obtain an acknowledgement of joint and several liability from joint executors or
administrators before permitting overdrafts in their names. This is usually included in the mandate form.

        Amounts of Debts Must be Certain: It is essential that the debts due from both the parties to each other must
be definitely ascertainable otherwise the right of set-off cannot be exercised. For example, a banker cannot set off
credit balance in the account of a guarantor of a loan account till his liability as a guarantor is determined. If the
guarantee is on demand, no debt in a owing by the guarantor payable until the demand is made and accordingly until
then there can be no right of set off. As soon as the demand is made the right of set-off can be exercised.

3. Banker’s Right of Appropriation (Rule in Clayton’s Case):

         In the course of his usual business, a banker receives payments fro his customer. If the latter has more than
one account or has taken more than one loan fro the banker, the question of appropriation of the money subsequently
deposited by him naturally arises. Section 59 to 61 of the Indian Contract Act, 1872 contains provisions regarding the
right of appropriation of payments in such cases.

         According to Section 59 such right of appropriation is vested in the debtor who makes a payment to his
creditor to whom he ownes several debts. He can appropriate the payment to his creditor to whom he owes several
debts. He can appropriate the payment by i) an express intimation r ii) under circumstances implying that the payment
is to be applied accordingly. For example, A owes B served debts, including Rs. 1,000 upon promissory note which
falls due on 1 December 1996. He owes B no other debt of the amount. On 1-12-1996 A pays B Rs. 1,000 the
payment is to be applied to the discharge of the promissory note.

If the debtor does not intimate or there is no other circumstances indicating to which debt the payment is to be
applied, the right of appropriation is vested in the creditor. He may apply it at his discretion to any lowful debt actually
due and payable to him from the debtor. (Sec 60)

        Further, where neither party makes any appropriation, the payment shall be applied in discharge of the debts
in order of time. If the debts are of equal standing the payment shall applied in discharge of each proportionately
(Sec, 61). In a recent case M/s Kharavela Industries Pvt. Ltd. Vs Orissa State Financial Corporation and Others (AIR
1985 Orissa 153 (A)), the question arose whether the payment made by the debtors was to be adjusted first towards
the principal or interest in his absence of any stipulation regarding appropriation of payments in he loan agreement.
The Court held that in the case of debt due with interest, any payment made by the debtor is in he first instance to be
applied towards satisfaction of interest and thereafter towards the principal unless there is an agreements to the

        In case a customer has a single account and he deposits and withdraws money from it frequently, the order in
which the credit entry will set off the debit money is the chronological order, as decided in the famous Clayton’s Case,
discussed below:

Clayton’s Case (Devaynes V. Noble : 1816)

       A firm of banker knows as Devaynes, Deives, Noble & Co., had five partners. Devaynes, the senior partner,
died and the surviving partners, carried on the business of banking under the same name. The executors of he
deceased partner objected to the continuance of the name of Devaynes in the firm’s name. After a year the firm
became bankrupt and various classes of creditors of the firm placed their claims against the estate of Devaynes, the
deceased partner.

        N. Clayton was one of the those creditors who continued to deal with the surviving partners by making
payments to and receiving payments from the firm. At the time of death of Devaynes, Clayton’s balance was $1,713.
During the next few days he withdrew several times and thus the balance was reduced to $453. Thereafter surviving
partners paid more than $1,713 to him and subsequently his deposits with the firm largely exceeded the amounts

withdrawn by him and thus his credit balance at the time of bankruptcy of the firm was larger than the amount which
was due to him at the time of death of Devaynes.

        Clayton claimed that the amount of $453 (as reduced by the divided on this amount which he received from
the Liquidator of the firm) was due to him from the estate of the deceased partner. His contention was that-

       i) the withdrawals from the account after the death of the partner were paid out of the deposits made in the
same period and thus.

          ii) the credit balance standing at the time of the partner’s death was recoverable from the deceased partner’s

       These arguments were not accepted by the Court and Clayton’s claim was rejected. Sir William Grant M.R.
observed the general rule of appropriation as follows:

         “This is the case of a banking account where all the sums paid in form one balanced fund, the parts of which
have no longer any district existence…… In such a case there is no room for any other appropriation than that which
arises from the order in which the receipts and payments take place and are carried into the account. Presumably, it
is the sum first paid in, that is first drawn out. It is the first item on the debit side of the account, that is discharged or
reduced, by the first item on the credit side.”

         Thus the first item on the debit side will be the item to be discharged or reduced by a subsequent item on the
credit side. The credit entries in the account adjust or set off the debit entries in the chronological order.

        The rule derived from the Clayton’s case is of great practical significance to the bankers. In case of death,
retirement or insolvency of a partner of a firm, then the existing debt due from the firm is adjusted or set off by
subsequent credit made in the deceased, retired or insolvent partner and may ultimately suffer the loss if the debt
cannot be recovered from the remaining partners.

         Therefore, to avoid the operation of the rule given in the Clayton’s case the bank closes the old account of the
firm and opens a new open in the name of the reconstituted firm. Thus the liability of the deceased, retired or
insolvent partner, as the case ay be, at the time of his death, retirement or insolvency is determined and he may be
held liable for the same. Subsequent deposits made by surviving/solvent partners will not be applicable to discharge
the same.

4. Right to Charge Interest and Commission

        The Banker has an implied right to charge a reasonable commission (known as bank charges) for its services
to the customer and interest on loans advanced. The right to charge interest may be either by express agreement or
by banking custom. The right to charge interest ceases on the death or insolvency of the customer.

        Simple interest is paid in the case of debts due to others. But in the case of bankers unless there is an
agreement to the contrary the customer has to pay interest once in a quarter. Where it is not paid in cash it will be
added to the principal and it amounts to compound interest. Bankers likewise make half-yearly interest payments on
the deposis they receive.

          Bank charges are levied in the case of overdrafts, cash credit and current accounts but not in the case of
Savings accounts. Where the customer maintains large balance in the current account, bankers waive these charges,
since it is profitable to have large balances without interest.

                                                     LESSON – 17

                                            NEGOTIABLE INSTRUMENTS

        Bills of Exchange, Cheques and Promissory Notes are the negotiable instruments with which the banker
mainly deals and therefore it is essential to know the law and practice relating to these instruments in great detail. Of
course, of the three instruments cheques are more important to bankers, but then most of the legal stipulations are
common to all the three instruments.

What is a Negotiable Instrument?

          Negotiable Instruments are essentially credit instruments with features of negotiability. Therefore, to clearly
understand them one should first understand their commercial character. Credit is the privilege to buy now and pay
later. It also includes borrowing of money now with a view to pay later. Instruments which evidence or acknowledge
such credits are called Credit Instruments. There are some credit instruments which are not negotiable. That is they
are credit instruments but they do not have the features of negotiable. I.O.U. (lowe you) and postal order are
examples of such non-negotiable credit instruments.

         Of the negotiable instruments, some are negotiable under law (i.e. Negotiable Instruments Act of 1881). While
the other are negotiable because of mercantile usage and custom, bills of exchange, promissory notes, and the
cheques are the three instruments which are negotiable under law. A detailed discussion of the three instruments
follows later, but at this stage a brief distinction between the three instruments is given. Suppose A sells goods worth
Rs. 1,000 to B on credit. The credit so allowed may be secured by means of different instruments which are given

         1. A may draw an unconditional order on B to pay the money himself or some other specified person. Such an
order is called the Bill of exchange.

       2. B may execute an unconditional promise to pay the money to A or his order. The instrument containing the
promise is called promissory note.

        3. B may draw a unconditional order on his banker (with whom he has deposited money on Current Account)
to pay A or his order a sum of Rs. 1,000 only. Such an order on the banker is called a cheque.

        Government of India Bonds and dividend warrants are examples of instruments which are negotiable
according to usage and custom. This is so because Government of India Bonds are similar to promissory notes and
dividend warrants are similar to cheques.

Definition of Negotiable Instruments

        The Negotiable Instruments Act does not define a negotiable instruments and merely states that ‘a negotiable
instruments means a promissory note, bill of exchange of cheque payable either to order or bearer” (Section 13). This
does not indicate the characteristics of negotiable instrument but only states that three instruments-cheque, bill of
exchange and promissory note – are negotiable instruments. These three instruments are, therefore, negotiable
instruments by statute. Section 13 does not prohibit any other instruments, which satisfies the essential features of
negotiability, to be treated as negotiable instrument. The essential feature of a negotiable instrument is its
negotiability as discussed below.

         Justice K.C. Willis defines a negotiable instrument as “one the property in which is acquired by any one who
takes it bonafide, and for value” not withstanding any defect of title in the person from whom he took it.

         Another useful definition is given by Thomas who states that ‘an instrument is negotiable when it is, by a
largely recognized custom of trade or by law, transferable by delivery or by endorsement and delivery, without notice
to the party liable, in such a way that a) the holder of its for the time being may sue upon it in his own name, and b)
the property in it passes to a bona fide transferee for value free from any defect in the title of the person from whom
he obtained it”.

        These definitions clearly reveal the true nature of a negotiable instrument. A negotiable instrument is a
transferable documents either by the application of the law or by the custom of the concerned. The special feature of
such an instrument is the privilege it confers on the person who receives it bona fide and for value, to posses good
title thereto ever if the transferor had no title or had defective title to the instrument.

Doctrine of Negotiability

        There are three essential qualities attached to a negotiable instrument.

        Firstly, a negotiable instruments must be transferable, that is the property in it-the legal ownership-must be
transferable by mere delivery, accompanied, in the case of an instrument payable to order, by endorsement. No
instrument of transfer is required and no notice of transfer need be given to the party/parties liable on the instrument.

          Secondly, it must give to the person who takes it in good faith, for value and without notice of any defect in
the title of the transferor, an indefeasible title against all comers. Also the title passes free from equities and counter-
claims between previous parties of which the transferee has no notice.

         Thirdly, a negotiable instruments must contain a right of action in itself, the possessor of it is deemed to be
the true owner capable of enforcing any claims thereon-be is under no duty to justify his title in the first instance.

Delivery: Delivery is defined as a transfer of possession from one person to another and is essential for the
negotiation of a negotiable instrument. If an instrument is to be negotiable, it must be possible to pass title ot the
instrument and the rights embodied in it by mere delivery or by delivery and endorsement, depending upon whether it
is payable to bearer or order. A document is not negotiable if title to it can only be transferred by some separate
document of transfer and/or the transfer is to be recorded in some reister of title as, for example, shares registered in
the books of the issuing company and represented by a share certificate. On the other hand, a share warrant in
bearer form and a bearer debenture which can be transferred by delivery, are negotiable.

        Delivery may be actual or constructive (Section 46). Actual delivery takes place by actual change of
possession of the instrument from one person to another. The instrument must be handed over physically to whom it
is actually intended to be delivered or to his authorized agent. For instance, when A, the holder of a negotiable
instrument payable to bearer, delivers it to B’s agent to be kept for B, the instrument has been negotiated.

        Constructive delivery implies that the instruments is not delivered or handed over to the person to whom it is
interned to be delivered but the possession of the instrument is in law deemed to have been transferred when delivery
is completed by some act which change the possession in the eyes of law form the transferor to the transferee. In
such a case the question of intention comes in.

         For example A, the holder of a negotiable instrument payable to bearer, which is in the hands of A’s banker
directs the banker to transfer the instrument to B’s account with him. The bank on accepting the instructions now
holds the instrument as a agent of B. The instrument has been negotiated and B has become the holder of it.

        Mode of Transfer: The mode of transfer provided by the Negotiable, Instruments Act depends upon the
character of instrument. According to Section 13 a negotiable instrument may be payable to :

        i) bearer, or

        ii) specified person or order

        While a bearer cheque passes by simple delivery, an order cheque passes by endorsement and delivery.

        An instrument is said to be payable to bearer which is simply so expressed “Pay bearer”, or which is
expressed thus. “Pay to Sham Lal or bearer”, or which having been made payable to a specified payee or his order
has been endorsed in blank, that is, he has written nothing more than his signature. In effect, an “endorsement in
blank” converts the “order” instrument into a bearer instrument. The legal right to the proceeds of a “bearer” cheque
passes from the drawer to whoever present if for pay.

        An instrument is payable to order which is payable to order of a specified person or which is payable to a
specified person or his order. An instrument in the form of “Pay to the order of A” is of the same effect as one drawn
payable to “A or order” which is payable to A or his order. With an order cheque the legal right to the proceeds of the
cheque passes from the drawer to the payee. If the payee wishes it to pass to another person be must endorse the
cheque to pass on the title.
        An instrument made payable to a particular person and not containing word prohibiting transfer or indicating
an intention that it shall not be transferable is defined to be instrument payable to order and is negotiable. Thus, the
word “order” or “bearer” are not necessary to render a cheque negotiable. For example, if a cheque is drawn ‘Pay A’
without the words ‘or order’ or ‘or bearer’ the cheque is transferable and negotiable and not payable only to ‘A’ in

         But it is unfortunate that some bankers are udder the wrong notion that a cheque from which the word ‘bearer’
is struck and there is no substitution of the word ‘order’ is not negotiable and they, therefore, refuse to pay such a
cheque unless presented by the payee himself in his banker.

Notice of Transfer or Instrument of Transfer Not Necessary: When a negotiable instrument, say a cheque, is
engorsed to someone, there is no need for either the endorser or endorsee to inform the drawer or to complete any
ancillary document. This characteristic is not true of non-negotiable instruments, as, for example, when any life
insurance policy is assigned to a banker as security for an advance, notice of assignemtn wil have to be given to the
insurance compant. In the cases of assignment of choses-in-action, it is necessary to give notice of assignmenrt to
the debtor or fund-holder so as to prevent him from dealing with the chose-in-action in a manner detrimental to the
interests of the assignee unless the debtor or fund-holder is a party to the assignment. A chose-in-action is a “thing”
to which a person has a right and can enforce that right by action in a court of law, but he does not actually have
possession of the “thing”. Life policies and debentures, for example, are chosen-in-action.

ii) Transfer of Title: The phrases ‘free from equities’ and ‘perfect title’ occur frequently in describing the rights of a
holder of a negotiable instrument. Other common phrases are ‘free from all deference” or “free from defects of title”.
These phrases all have the same ultimate meaning and it is important that the meaning is grasped soundly at an early

          An equity defence or defect refers to a sustainable reason for disputing or refusing payment of the bill. If a
cheque is issued for goods which prove to be defective or substandard, the drawer has grounds for stopping the
cheque refusing payment. This is an equity or defence against the payee. Similarly, a bearer cheque which has been
lost or stolen has thereafter an equity or defence against the payee. Similarly, a bearer cheque whch has been lost or
stolen has thereafter an equity or defence attached to it. The finder of thief is a wrongful possessor. The drawer has
the right to refuse payment s the finder’s or thief’s title is defective. In both these instances, under the basic rule of
transferability, the new holder would take the cheque subject to equities. That is he would inherit all the weaknesses
in the title of his transfer and any defence or argument which could be raised against the transfer could be sustained
equally well against the new holder.

          A negotiable instrument gives to a party who takes it in good faith, for value and without notice of any defect
in the title of the transfer, an indefeasible title against all parties and he will not be affected by any prior defect in the

         The title to the instrument passes free from defects in the title of previous parties and from all counter-claims
between the parties. So paramount is the quality of conferring a good title that a party taking a stolen negotiable
instrument under the conditions just mentioned would have a good title against the party from whom it has been
stolen. The recipient party and the holders of the documents subsequent to him may disregard the defects in title and
enforce the document as if it were in every respect perfect.

        The legal relations hip between the person first bound and the person first entitled on a negotiable instrument
is one of contract and in law there is a basic principle that only the immediate parties to a contract may be entitled on
and be bound by it. The principle of negotiation, applicable to bills of exchange (including cheques), is an exception to
the aforesaid basic principle as shown above.

           Again, in law there is a principle that a person with a defective title to property may not normally give a person
to whom he transfers the property a better title than he himself has. This is often expressed in the Latin maxim nemo
dat quod non habet (Nobody can give what he has not got). If the transfer had a defective title, the same defective
title is the only title which he could transfer. When a person obtains property from one who is dealing with it without
the authority of the true owner, no title is acquired against the true owner unless the principle of estoppels operates
against him. Thus, a buyer cannot get a valid title to stolen goods sold to him by the thief even if the buyers has no
notice of theft. Negotiability is also an exception to this principle.

In the case of negotiable instrument, a bonafide transferee for value acquires a god title subject to his satisfying
certain conditions even if the title of the transferor were defective. Such a transferee is known as a “holder in due
course”, and he may, in fact get a better title than the transferor. For instance, if a bearer cheque is stolen and the
thief transfers it for value to an innocent third party, the latter would get a perfect title provided he qualifies as holder
in due course. The transferee is generally not required to investigate the transferor’s title to the instrument because
the negotiable instruments are intended to be dealt with speedily.

        Thus, it is the exceptions to these two principles of nemo dat quod non habet and privity that constituties the
essence of negotiability. In other words, when a bill of exchange (including cheque) is negotiated (either by delivery or
by delivery plus endorsement) the new holder can, under specified circumstances, take the bill ‘free from equities’
Arguments, disputes or reasons for refusing payment against the original holder cannot be raised against the new

iii) An Action in Law: If a cheque or bill is dishonoured when presented for payment, the holder can sue on it in his
own right. He does not have to claim through who transferred he instruments to him. There is right of action in he
instrument itself.

       Because of the characteristics mentioned above, negotiable instruments can pass freely from hand to hand.
The negotiability can, however, be destroyed if it contains words to that effect as, for example, in the case of cheque
crossed “Not Negotiable”

                                              Types of Negotiable Instruments

           Though the negotiable instruments posses the above-mentioned features, they fall under two categories as

        i) Negotiable Instruments by Statute: As already stated the Negotiable, instruments Act states three
instruments-cheque, bill of exchange and promissory notes-as negotiable instruments. They are, therefore called
negotiable instruments by statute.

         ii) Negotiable Instruments by Custom or Usage: Some other instruments have acquired the character of
negotiability by the custom or usage of trade. Section 137 of the Transfer of Property Act., 1882 also recognized that
an instrument may be negotiable by law or custom. Thus in India Governments Promissory notes Shah Jog hundis,
delivery orders and railway receipts have been held to be negotiable by usage or custom of the trade.

        Exceptional Case of Negotiable Instruments: Generally the negotiable instruments possess all the essential
features discussed above. But sometimes the drawer or the holder may take away the essential characteristic of
negotiability and thus the instrument ceases to be a transferable or negotiable instrument.

         Examples: i) If a cheque is payable to a specific person only and not to his order or the bearer, it cannot be
transferred to any other person and hence it loses its negotiability. ii) if a cheque is crossed ‘Not Negotiable’, it can be
transferred but without conferring on the transferee absolute and good title in all cases. The transferee of such a
cheque will stand at par with the transferee of any other commodity and shall not posses title better than that of his

Definitions of Promissory Note, Bill of Exchange and Cheque

         Promissory Note: A ‘promissory note’ is an instrument in writing (not being a bank not or a currency note)
containing an unconditional undertaking, signed by the maker, to pay a certain sum of money only to, or to the order
of, a certain person or to the bearer of the instrument (Section 4)

           From this definition, it is clear that a promissory note

         1. must be in writing,
         2. must contain an undertaking or promise to pay. Thus, a mere acknowledgement of indebtedness is not

         Also, a receipt for money, if it does not contain express promise to pay is not a promissory note. But, if the
receipt is coupled with a promise to pay, it shall be a promissory note.

Example : “We have received a sum of Rs. 9,000 from Shri R.R. Sharma. This amount will be repaid on demand. We
have received this amount in cash” Held, this is a promissory note (Surjit Singh Vs. Ram Ratan)

         However notice, that the use of the word ‘promise’ is not essential to constitue an instruments as ‘promissory

         3. the promise to pay must not be conditional. Thus, instruments payable on performance or non-performance
of a particular act or on the happening or non-happening of an event are not promissory notes.

Example : i) A promises to pay B Rs. 5000 provided C leaves sufficient money in favour of A after C’s death, is not a
promissory note.

         ii) A promises to pay B Rs. 5,000 seven days after his marriage with C, is again not a promissory note.

       However, the promise to pay may be subject to a condition which according to the ordinary experience of
mankind is bound to happen. Thus, where A promises to pay B Rs. 5,000 after the death of C, it is not a conditional
promise because it is certain that C shall die and hence it is a valid promissory note.

         4. The undertaking must be to pay a certain sum of money. For instance where the promise is to pay, say Rs.
10,000 with interest, it is not a promissory note. But, however, where rate of interest is specified it makes the sum

         5. The money may be payable either to or to the order of a certain person or to the bearer of the note.

         6. It must be signed by the maker.

Examples of Promissory Note

         1. I promise to pay B or order Rs. 500.
         2. I acknowledge myself indebted to B in Rs. 1,000 to be paid on demand for value received.

         The following are not promissory notes.

         1.   Mr. B.I.O.U (I owe you) Rs. 500
         2.   I am liable to pay you Rs.500
         3.   “I promise to pay B Rs. 5,000 and all other sums which shall be due to him”.
         4.   “I promise to pay B Rs. 5,000, first deducting thereout any money which he may owe me”
         5.   “I promise to pay B Rs. 10,000 seven days after my marriage with C”
         6.   “I promise to pay B Rs. 10,000 on D’s death, provided D leaves me enough to pay that sum”.
         7.   “I promise to pay B Rs. 5,000 and to deliver him my black horse on 1 January next”

         Rs. 10,000                                                       New Delhi 110 016

         Oct. 13, 1987

         Six months after date I promise to pay X or order the sum of Rupees Ten Thousand only for value received.

         To X



         On the basis of the above discussion, we may summarize the basic features of a promissory note as given


Essentials or Characteristics of a Promissory Note

         1.  It must be stamped.
         2.  It must contain a promise or undertaking to pay
         3.  The promise must not be conditional
         4.  The undertaking must be to pay certain sum of money
         5.  It may be payable on demand or after a particular date
         6.  It cannot be payable to bearer (Sec 31 or RBI Act)
         7.  It cannot be payable to bearer on demand (Sec 31 of RBI Act)
         8.  It cannot be crossed like a cheque
         9.  Number, place, date, etc., are not essential for a promissory not. If it does not bear a date, it is deemed to
             have been made when it was delivered
         10. It may be payable by installments.


Bills of Exchange

         A ‘bill of exchange’ is defined by Sec. 5 of the Negotiable Instrument Act., 1881 as “an instrument in writing,
containing an unconditional order, signed by the makers, directing a certain person to pay a certain sum of money
only to or to the order of, a certain person, or to the bearer of the instruments”. In England, a bill of exchange is
defined under Section 3 (1) of the Bill of Exchange Act as ‘an unconditional order in writing, addressed by one person
to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand or at a fixed
or determinable future time a sum certain in money to or to the order of a specific person, or to the bearer”. Both
these definitions points out that a bill exchange should be 1) in writing, 2) unconditional, 3) in the form of an order not
a promise or request, 4) for a sum of money, not for a sum of money, not for a commodity or anything and 5) payable
to a certain person or to his order or to the bearer of the instrument.
         Rs. 10,000                                                       New Delhi 110 016

         Oct. 13, 1987

         Six months after date pay to order the sum of Rupees Ten Thousand only for value received.

         To Z



       The specimen given above is of a usance bill, payable after a specified period of time. A bill of exchange may
be drawn payable ‘at sight’ i.e. on demand or payable ‘after certain time after sight’

         Basic features of a bill exchange may be summed up as hereunder.

Essentials or Characteristics of a Bills of Exchange

       1.    It must be stamped
       2.    It contains an order to pay
       3.    Order must be unconditional
       4.    Sum payable must be certain
       5.    May be drawn payable to bearer
       6.    Cannot be made payable to bearer on demand
       7.    Cannot be crossed like a cheque
       8.    Requires acceptance by the drawee unless payable on demand
       9.    It is dishonoured by non-acceptance or non-payment
       10.   It may be payable by instalments



        A cheque is defined as “a bill of exchange drawn on a specified banker and not expressed to be payable
otherwise than on demand”. (Section 6 of the Negotiable Instruments Act, 1881). Thus a cheque is a bill of exchange
but always drawn on a specified banker and is always payable on demand, not otherwise.

Distinction between Promissory Note and Bill of Exchange

       Promissory note differs from a bill of exchange in the following respects.

          Promissory Note                                                   Bill of Exchange

          1. There are only two parties, the maker                          There are three parties – the drawer, the
          (debtor) and the payee (creditor)                                 drawee and the payee, although any two of
                                                                            these capacities may be filled by one and the
                                                                            same person

          2. A note contains an unconditional promise by                    It contains an unconditional order to the
          the maker to pay the payee                                        drawee to pay according to the drawer’s

          3. No prior acceptance is needed                                  A bill payable ‘after sight’ must be accepted by
                                                                            the drawee or his agent before it is presented
                                                                            for payment.

          4. The liability of the maker on drawer is                        The liability of the drawer is secondary and
          primary and absolute.                                             conditional upon non-payment by the drawee

          5. No notice of dishonour need be given                           Notice of dishonour must be given by the
                                                                            holder to the drawer and the intermediate
                                                                            indorsers to hold them liable thereon.

          6. The maker of the note stands in relation with                  The maker or drawer does immediate not stand
          the payee                                                         in intermediate relation with the payee but with
                                                                            the acceptor or drawee.

Difference between Bill of Exchange and Cheque

        Though a cheque is defined as a bill of exchange, it differs from the latter in the following respects.

          Cheque                                              Bill of Exchange

          1. It must be drawn only on a banker                It can be drawn on any person including a

          2. The amount is always payable on demand.          The amount may be payable on demand or
                                                              after a specified time.

          3. The holder of a cheque is of grace               A holder of a bill is entitled not entitled to day to
                                                              three days of grace

          4. Acceptance is not needed                         A bill payable after sight must be accepted

          5. A cheque can be crossed                          Crossing of a bill of exchange is not possible

          6. Notice of dishonour is not necessary. The        Notice of dishonour is necessary to hold the
          parties thereon remain liable, even if no notice    parties liable thereon. A party which does not
          of dishonour is given                               receive a notice of dishonour can generally
                                                              escape is liability thereon

          7. A cheque is not to be noted or protested in      A bill is noted or protested to establish
          case of dishonour                                   dishonour

          8. The protection given to the paying banker in     No such protection is available in the case of
          respect of crossed cheques is peculiar to this      bills

        Distinguishing Features of Cheques, Bill of Exchange and Promissory Note:

        Based on the above statutory definitions, the following are the distinguishing features of the three negotiable
instruments indicating the similarities and contracts between them:

1. Instruments in writing : The low requires that a cheque, bill or promissory note must be an instrument in writing. It
does not specify any particular material with which it is to be written. Though a negotiable instruments written with a
pencil is not prohibited by law, in practice the bankers do not accept such instruments because of risk involved
Alternations therein may be easily made which cannot be detected.

2. Unconditional order/promise: A cheque and a bill of exchange contain an order to the drawee whereas a
promissory note contains a promise by the maker to his creditor. Thus the main difference between a cheque and a
bill on the one hand and a promissory note on the other is that the cheque and the bill contain an order from the
creditor to the debtor to pay a sum of money while he promissory note contains an undertaking or promise made by
the debtor to his creditor to pay the sum specified therein.

        However, there is one common feature of a promissory note, cheque and a bill. The promise in the former
and the order in the latter must be an unconditional one i.e., the payment should not be made dependent upon the
happening or occurrence of a particular event or on the fulfillment of any condition. But if the time for payment of the
amount (or any of its installments) is expressed to be on the lapse of a certain period after he occurrence of specified
event, the promise or order to pay is not deemed ‘conditional’ provided the event is certain to happen according to
ordinary expectation of mankind, although the time of its happening may be uncertain (Section 5) Thus, a distinction
may be made between an event which is bound to take place according to human expectation and the one which may
or may not at all take place according to human expectation and the one which may or may not at all take place. For
example, the death of a particular person is an event which shall definitely take place, its timing ma be uncertain. But
the marriage of a person, or his departure to or return from a foreign country are events which are uncertain to take
place. The banker may refuse to honour a cheque having conditional order of the drawer. The drawer of a cheque

may, however, cross the cheques and thereby instruct the banker the manner in which and the intermediary through
which the payment is to be made. Such instructions do not make the order of the drawer a conditional one.

         The words in the cheque or the bill must be in the nature of an order rather than a request, though it is not
necessary that the word ‘order’ is specifically mentioned therein. Words of courtesy, if any such as ‘please’ do not
make the instruments invalid on this ground. The words in the promissory note should also amount to an
unconditional promise to pay the specified amount, otherwise it will not be treated as a promissory note. For example,
in the following cases, unconditional promise is not given by the writer of the note:

        1.    Mr. B.I.O.U (I owe you) Rs. 500
        2.    I am liable to pay you Rs.500
        3.    “I promise to pay B Rs. 5,00 and all other sums which shall be due to him”.
        4.    “I promise to pay B Rs. 5,00, first deducting thereout any money which he may owe me”
        5.    “I promise to pay B Rs. 500 seven days after my marriage with C”
        6.    “I promise to pay B Rs. 500 on D’s death, provided D leaves me enough to pay that sum”.
        7.    “I promise to pay B Rs. 500 and to deliver him my black horse on 1 January next”

        In the following case, the writer of the promissory note makes an unconditional promise.

        i)       I promise to pay B or order Rs. 5,000.
        ii)      I acknowledge myself indebted to B in Rs. 1,000 to be paid on demand, for value received.

3. The drawee of a cheque or bill : The main difference between a cheque and a bill is that the former is always
drawn on and is payable by a banker specified therein, while a bill of exchange may be drawn on any person, firm or
company. Thus only a customer of a bank having a current or a savings bank account is entitled to draw a cheque on
his banker i.e., the particular branch of a bank where he has opened his bank account. The name and address of the
drawee bank are specifically printed on the cheque form. A bill of exchange is generally drawn by a seller on his
customer, or by a creditor on his debtor. Sometimes accommodation bills are also drawn to help a familiar party.

4. The amount of the instrument must be certain: The order of the drawer of a cheque or a bill and the promise by
the writer of a promissory note must be to pay a certain sum of money and not anything else, e.g., securities or
goods, etc. The amount of money to be paid must be certain and specified in words and figures. According to Section
5, the sum payable may be ‘certain’ although.
         i) it includes future interest, or
         ii) it is payable at an indicated rate of exchange, or
         iii)       it is according to the course of exchange, or
         iv)        the instrument provides that on default of payment of an instalment, the balance unpaid shall become

The amount may be mentioned in a foreign currency as well, provided the rate of conversion of the domestic currency
into foreign currency is stated by the drawer or is left to be decided according to the market conditions.

5. The instrument must be payable either ‘to order’ or ‘to bearer’: According to Section 13, a promissory note, bill
of exchange or cheque must be payable either ‘to order’ or ‘to bearer’. The meanings of these words are explained as

i) Payable to order: A promissory note, bill of exchange or cheque is payable to order if it is expressed to be so
payable or if it expressed to be payable to a particular person and does not contain words which prohibit its transfer or
which indicate an intention that it shall not be transferable. For example, if a cheque is drawn as “Pay to Ram Lal” its
payment may be made to Ram Lal or any person as per his order. The cheque can be endorsed, even if it does not
contain the words “or order”. But if he cheque is drawn as “Pay to Ram Lal only”, it cannot be endorsed by Ram Lal
because the word “only” shows the intention of the drawer to restrict its further transfer. Such a cheque shall be
payable to Ram Lal only.

           If a negotiable instrument, either originally or by endorsement, is expressed to be payable to the order of a
specified person, and not to him or his order, it is nevertheless payable to him or his order at his option. For example,
if a bill of exchange is expressed as ‘pay to the order of Radhey Shyam or order”, it is still payable to Radhey Shyam
or if he so chooses to the person specified by him.

ii) Payable to bearer: A promissory note, bill of exchange and cheque are payable to bearer a) if it is expressed to be
so payable, or b) if the only or the last endorsement is an endorsement in blank. This means a cheque payable ‘to
order’ becomes a bearer cheque if it is endorsed in blank.

        If the word bearer printed on a cheque form is scored off, it does not make the cheque non-transferable or
non-negotiable, nor does not it render it payable only to the payee. Such a cheque remains payable to order and is
negotiable as such, (M. George & Brothers V. Cherian, 1990 (1) Kerala Law Times 133).

6. The payee must be a certain person: The person to whom payment of he instrument is to be made must be
certain. The payee is considered as ‘certain person’ for this purpose even if he is mis-named or is designated by
description only (Section 5). The term ‘person’ includes, besides individuals, bodies corporate, local authorities
societies and associations of persons, etc., and cheque may be drawn payable to the Registrar, Principal, Director,
Secretary, etc., of these institutions.

7. The payee may be more than one person: A negotiable instrument may be made payable to two or more payees
jointly or it may be made payable in the alternative to one of two or one of some of several payees (Section 13(2)).
For example, a cheque may be payable to-
         Ram and Shyam or Ram or Shyam
         In both these cases, it is payable to a certain person.

8. The time of payment: A cheque is always payable on demand, through words to this effect are not mentioned
therein. A bill may be payable at sight or after a period of time specified therein. A promissory not or a bill of exchange
in which no time for payment is specified is payable on demand (Section 19). If a bill is payable after a certain period
it must be accepted by a drawee. But no such acceptance is necessary in case of a cheque. If cheque is a post-dated
cheque is does not constitute an order to the banker till the date specified therein approaches Banks do not make
payment of such cheques before the date given in the cheques.

9. Signature of the drawer /promissor: A negotiable instrument is valid only if it bears the signature of the
drawer/promisor.In case of a cheque the signature of the drawer must tally with his specimen signature given to the
banker at the time of opening his account.

10. Delivery of a instrument is essential: A promissory note, bill of exchange and the cheque is a negotiable
instrument. The making, acceptance or endorsement of such an instrument is completed by delivery (Section 46).
This means that a negotiable instrument is deemed to have been drawn, when it is written by the person concerned
and delivered to the other party to whom it is meant. Delivery may be either actual or constructive.

11. Stamping of promissory notes and bills of exchange is necessary: The Indian Stamp Act, 1899 requires that
the promissory note and the bills of exchange must be stamped. This is not required in case of a cheque. The value
of stamp depends upon the value of the note or the bill and whether it is payable on demand or at a future date. A
note or bill without stamp cannot be admitted in evidence. It may be stamped either before or at the time of its

        Currency Notes and Negotiable Instruments: The currency notes posses all the qualities of a negotiable
instrument. In fact a currency note is a promissory note (except in case of inconvertible currency) issued by he
monetary authorities of a country payable to bearer on demand. The right to issue such currency notes is now being
conferred on the central banks of all the countries. In order to prohibit any other person or institution from issuing such
promissory notes payable to bearer on demand, Section 31 of the Reserve Bank of India Act., 1934, specifically lays
down that.

        “No person in India other than the Reserve Bank or, as expressly authorized by this Act, the Central
Government, shall draw, accept, make or issue any bill of exchange, hundi, promissory note or engagement for the
payment of money payable to bearer on demand, or borrow, owe or take up any sum or sums of money on the bills,
hundis or notes payable to bearer on demand of any such person:
        Provided that cheques or drafts including hundis payable to bearer on demand or otherwise, may be drawn
on a person’s account with a banker, shroff or agent”.

         This Section prevents persons (except the Reserve Bank and the Central Government) from drawing,
accepting, making or issuing a bill or note payable to bearer on demand. This restriction is imposed with the object
that instruments similar to currency notes are not issued by a private party. However, bearer cheques or drafts
payable on demand may be issued on the drawer’s personal account with a banker or an agent.
                                                    LESSON – 18

                                  DIFFERENT TYPES OF ACCOUNTS IN A BANK

         A Bank is essentially an intermediary of short term funds. He can carry out extensive lending operations only
when he can effectively channelise the savings of the community. A good banker is one who effectively mobilizes the
savings of the community as well as makes such use of savings by making it available to productive and prior sectors
of economy thereby fostering the growth and development of Nation’s economy. Traditionally the banker used to
accept there types of deposits viz., current, fixed and savings deposits. But because of the intense competition for
resources, there are a variety of other innovations introduced by the bankers in recent times. The practice, forms and
legal incidents relating to such deposits are discussed in this chapter.

Form of Deposits

        From the standpoint of withdrawal, deposits accepted by banks fall into two categories, demand deposits and
time deposits.
        Demand deposits are payable on demand and can be withdrawn without previous notice to the bank. These
deposits are maintained by the depositors who have need for liquid balance, and include current accounts, savings
accounts up to a specified limit and call deposits.
        Any deposit which is not repayable on demand, or a deposit which is repayable on a fixed date or after a
period of notice is a time deposit. Such deposits include fixed deposits, notice deposits (i.e., payable after a notice
period) and recurring/cumulative deposits.

Current Accounts

         A current account is a running and active account which may be operated upon any number of times during a
working day. There is no restriction on the number and the amount of withdrawals from a current account. AS the
banker is under an obligation to repay these deposits on demand, they are called demand liabilities of a banker. To
meet such liability the banker keeps sufficient cash reserves against such deposits vis-à-vis the savings and the fixed
deposits. Current accounts suit the requirements of big businessmen, joint stock companies, institutions, public
authorities and public corporations, etc., whose banking transactions happen to be numerous on every working day.
Special characteristics of a current account are as follows:

        1. A current account is meant for the convenience of his customers, who are relieved of the task of handling
cash themselves and to take the risk inherent therein. Thus the primary object of a current account differs from the
object of other deposit accounts which are meant to solicit the savings of the people.

        2. As the banker undertakes to make payments and to collect the bills, drafts, cheques, etc., any number of
times daily, the operating cost, i.e., the cost of bank personnel involved in current account is considerable. It is,
therefore, customary for the banks not to pay any interest on the credit balance in the current account. The Reserve
Bank directive prohibits the payment of interest on current account. No countervailing interest is payable on any
current account maintained by a borrower with any bank, Banks may pay interest on current account of Regional
Rural Banks at half per cent below the borrowing rate fixed for the RRB by the sponsor bank.

       Sinced May 1983, banks have been permitted to pay interest on balances lying in current accounts in the
name of a deceased depositor from the date of death of the depositor till payment to the legal heirs. Interest on such
amount shall be payable at savings bank deposit rate.

        3. Banks makes no charge for keeping an account provided the balance maintained is sufficient to
compensate the bank for work involved. In case of unemunerative accounts involving lot of work but without the
maintenance of sufficient balance, the banker charges indicidental expenses from the customer. The public sector
banks now impose a uniform ‘Ledger folio charge’ of Rs. 20 per folio (i.e. one side of the ledger page) on accounts
having average balance below Rs. 25,000.
        4. A current account carries certain privileges which are not given to a savings bank account-holder, e.g.,

        i) Third party cheques with endorsement may be deposited in the current account for collection and credit.
        ii) Overdraft facilities are given is case of current accounts only.
        iii) The loans and advances granted by the banks to their customers are not given in the form of cash but
through the current accounts. Current accounts thus earn interest on all types of advances by the banker.

Savings Accounts

         Savings accounts are mainly meant for non-trading customers who have some potential for saving and who
do not have numerous transactions entering their account. Salaried classes of the lower and middle income group,
small traders and farmers mainly open such accounts.

Who can open a Savings Accounts?

        1. By a person on his/her own behalf.
        2. By more than one person payable to any one or more of them or survivor or survivors.
        3. By a guardian on behalf of minor, in which case a declaration as to the date of birth of the minor should
           be obtained from the guardian.
        4. By the minor himself/herself for reasonable amounts provided the minor produces satisfactory proof
           about his/her date of birth.
        5. By one person for another person with the stipulation that the deposit can be withdrawn by the latter only
           on his or her attaining the majority or marriage or some other specified time.
        6. By Secretaries, Treasurers, Managers or other officers of non-trading concerns such as schools, clubs,
           hospitals, religious and charitable instritutions. However in these cases, the rules and by-laws governing
           such institutions and all other necessary information should be furnished to the bank when the account is
        7. Savings Bank Account in the name of Trading Concern (be it a proprietorship, firm or joint stock
           company) can be opened for placing their special funds such as Provident fund etc. But they cannot open
           Savings Bank Accounts for conducting trade.

Some of the features of Savings Accounts

        1. Accounts could be opened with a minimum of five rupees. The smallest amount that may be deposited or
withdrawn at any time is Re. 1. A minimum balance of Rs. 5 should be maintained in the account and the account
may be closed if for a continuous period of six months or over account shows a balance below the minimum.

        2. Every a depositor is permitted a maximum of 25 withdrawals in a quarter whether by cheque or otherwise.
The total amount of one or more withdrawals on any day should not exceed 10% of the balance in the account or Rs.
1,000 whichever is greater, unless 10 days advance notice is given.

       3. Banks have introduced the practice of imposing a service charge of Rs. 10 per annum on these savings
accounts in which-

       i) The minimum balance is not maintained. This minimum balance is Rs. 500 for savings accounts with
cheque facility: (Subject o variation between banks/branches).

        ii) The number of withdrawals exceeds the above limit and

       iii) the amount of withdrawals exceeds the specified limit. Banks waive this charge in case of respectable

        Payment of Interest : The rate of interest payable by the banks on deposits maintained in savings accounts is
prescribed by the Reserve Bank. At present the rate of interest on savings deposits is 4.5%. Scheduled commercial
banks with deposits less than Rs. 25 crores may, at their discretion, give an additional interest of ½ per cent. The
above rate of interest is payable irrespective of whether cheque facility is extended or not.

         Interest is calculated at quarterly or longer rests on the minimum balance to the credit of the account during
the period from the tenth day to the last day of each calendar month on every complete sum of Rs. 10 and is credited
to the account. The State Bank of India credits interest once in a year.

Fixed Deposit Accounts

       Fixed deposits or term deposits are accepted for a period at a fixed rate of interest agreed upon, depending
upon the period for which they are accepted. At the end of the fixed period, the depositor may either withdraw the
amount or renew the deposit for a further fixed period. Fixed deposit received for a period of, say, less than 12
months are called short-term deposits. The fixing of period in advance enables the bankers to employ the funds more
profitably without keeping a cash reserve to meet the drawings. The banker, therefore, offers a higher rate of interest
on such deposits because the depositors part with liquidity for a definite period. Fixed deposits are very popular
among banks because they provide stable funds.

        Apart from the traditional type of fixed deposits, banks now offer different types of deposit schemes to meet
diverse needs of the public and to attract different classes of savers in the community. Such schemes include
recurring/cumulative deposits reinvestment plan deposits, monthly income plan, retirement income plan, child
education plan, marriage plan, housing loan linked deposits, etc. All these deposits indicated product differentiation of
term deposits since the deposits rate schedule is determined by the Reserve Bank of India.

        If a deposit is made for a fixed period, it becomes repayable at the expieration of that period without the
customer making any demand. If, however, a depositor allows money due under a fixed deposit to be with the banker,
an intention to treat the deposit as one payable on demand could be inferred, thus making the period of limitation of
three years run only form the date of demand as was also held by the Jammu and Kashmir High Court in Jammu and
Kashmir Bank Ltd., V. Nirmala Devi (1959).

          By its very nature a fixed deposit cannot be drawn on by a cheque. A bank whose customer draws a cheque
for an amount exceeding the credit balance in his current account would, therefore, be perfectly justified in
dishonouring it, despite the fact that the amount standing to the credit of his fixed deposit is sufficient to meet the
excess. In actual practice, however, banks usually honour cheques drawn in these circumstances and rely on their
right of set-off to recoup the excess amount of the cheque out of the customer’s fixed deposit account.

Notice Deposit

        Notice deposits are time deposits withdrawable at a certain notice to be given by he depositor. The notice in
writing may have to be given 15 days or more in advance before the money can be withdrawn. Deposits requiring
longer notice carry a higher rate of interest than those requiring shorter notice.

Rate of Interest of Fixed Deposits

        The rate of interest and other terms and conditions on fixed deposits accepted by banks are regulated by the
Reserve Bank of India in exercise of the powers conferred upon it by sections 21 and 35A of the Banking Regulation
Act. 1949. Fixed deposits are classified into various categories with varying periods of maturities starting form 15 days
and ending with 5 years or more. The longer the period, the higher is the rate of interest and this provides an
incentive to the depositors to get higher rate of interest on deposits for a longer period. Smaller banks are allowed to
pay slightly higher rate of interest on various categories of fixed deposits. Interest is payable at the stipulated rate at
the maturity of the fixed deposit receipt. However, banks usually pay interest half-yearly at the close of June and
December (now March and September) each year at the request of the depositor. Interest ceases on the maturity of
the deposit but in case of renewal overdue interest on the deposit may be allowed with effect from the due date
according to bank rules.

Fixed Deposit Account – Deposit Receipt

         When a fixed deposit account is opened, the depositor is required to fill in an account opening from and the
banker issues the receipt mentioning the amount of fixed deposit accepted, the name of the depositor, the rate of
interest allowed and the period for which the amount is deposited. The due date is also mentioned on the receipt
except in ht case of notice deposits.

        The rules relating to the fixed deposits are printed on the back of the receipt for the information of the
depositor. The receipts are not transferable by endorsement and delivery. However, the proceeds of the deposit
receipts may be paid to a third party or to a collecting banker on the due date is the receipt is presented duly
discharged along with an appropriate letter of authority signed by the depositor authorizing payment to the third party
for which proper identification should be obtained or to the collecting banker, as the case may be.

Repayment/Renewal/Prepayment of Fixed Deposits

        If cash payment of the deposit receipt is to be made on the due date, it is necessary to have the receipt
discharged by the depositor on a revenue stamp of 20p. In the case of renewal, mere discharge of the depositor
without stamped receipt is sufficient. Even the discharge is waived in case the renewal instructions of the depositor
are contained in a covering letter accompanying the deposit receipt. In case of renewal surrender of the original
receipt is a must.

         If the depositor require s money before the due date, two courses are open to him. He should approach the
bank either to encash the deposit receipt before the due date or to rais a loan there against. The bank has the
discretion to encash the deposit receipt at he rate of two per cent below the rate applicable to the period for which the
deposit has run, as per schedule of rates prevailing at the time when the deposit was originally accepted. Interest
already paid on the deposit, if any, should be taken into account at the time of encashment. Alternately, the loan is
granted at a rate two per cent higher than the rate allowed on the deposit and a margin of 25 per cent is kept. In either
case, the receipt should be discharged by all the depositors and in the case of a prepayment, a letter of request and
in the case of a prepayment, a letter of request and in the case of a loan, a letter of pledge should be signed by all the
depositors, even if the deposit is payable to either or survivor or to anyone or survivor.

Loss of Deposit Receipt

          In case of loss of deposit receipt, the amount can be paid to the depositor on the due date, or a duplicate
deposit receipt can be issued against an ordinary indemnity as a deposit receipt is not transferable and cannot be
legally transferred to a third party.

Recurring Deposit or Cumulative Deposit Accounts

         A variant of the savings banks accounts is the recurring deposit or cumulative deposit account introduced by
banks in recent years. This account is intended to inculcate the habit of savings on a regular basis as an inducement
is offered in the form of comparatively higher rate of interest. A depositor opening a recurring deposit account is
required to deposit an amount chosen by him, generally a multiple of Rs. 5 or 10, in his account every month for a
period selected by him. The period of recurring deposit varies from bank to bank. Banks open such accounts for
periods ranging form 1 to 10 years.

         The rate of interest on the recurring deposit account stands favourably as compared to the rate of interest on
the savings bank account because the former partly resembles the fixed deposit account. According to the directive of
the Reserve Bank, Bank are required to ensure that the rates of interest offered by them on recurring deposits are
generally in accord with the rates prescribed for various term deposits. The rate of interest is, therefore, almost equal
to that of the fixed deposit account.

        Incase a depositor is compelled to close the account before its maturity, the bank pays no interest if the
deposits are made for less than 3 months, interest at 1 ½ % is payable for deposits made up to 6 months, up to 4%
for deposits made up to 12 months and 1% below the rate applicable to a recurring deposit of the period for which the
deposit has actually run in case of deposits are held for over year, the accounts are transferable from one branch to
another without charge.

         The recurring deposit account can be opened by any person, more than one person jointly or severally, by a
guardian in the name of a minor and even by a minor. While opening the account, the depositor is given Pass Book
which is to be presented to the bank at the time of monthly deposit and repayment of amount. Accumulated amount
with interest will be payable a month after the payment of the last installment.

Opening of Current and Saving Accounts

By opening an account with the banker, a customer enters into relationship with a banker. The banks should be very
careful in opening an account in the name of a customer. The banker reserves the right to open account on being
satisfied about he identity of he customer. The following precautions should be taken in this regard.

         1. Application on the Prescribed Form: The request for opening a savings or current account is made on the
prescribed form of the bank concerned. Banks provide separate application forms for opening savings and current
accounts for individual, partnership firms and companies. The applicant is required to mention his name, occupation,
full address, specimen signature and the name and signature of a referee. He also undertakes to comply with the
bank’s rules in force form time to time for the conduct of the account. It means that the rules prevalent at the time of
opening of an account may be changed or modified by the banker and such modified rules shall be acceptable to the
customer. The Reserve Bank of India has asked all commercial banks to obtain photographs of the depositor/account
holders who are authorized to operate the accounts, at the time of opening of new accounts.

        Banks generally print different forms for individuals, companies, partnerships, executors, joint accounts etc. In
the case of applications printed for individuals the following points amongst other things are mentioned.

       a) In the matter of collection of cheques, bills etc. at places where the bank has not branches the banker is
requested to collect them through any bank at his risk and responsibility.

         b) In the case of bills discounted by the banker the applicant agrees to reimburse the banker if the latter fails
to realize such bills.

        c) He agrees to be bound by the bank’s rules for the time being in force for the conduct of such accounts. He
also declares that the rules in force have been read by/to him.

        d) In the case of illiterates the form provides for an undertaking to call in person for withdrawing money from
the account, and restraining his from issuing cheques in favour of third parties.

       These stipulations are binding on the customer and as such will considerably minimize the risk of the banking

        2. Introduction of the Applicant : Before opening a savings or current account in the name of an intending
customer, the banker must get true identity of the former in order to ensure that he is a respectable person. The
banker thus, reserves the right not to open an account in the name of a person whose true identity has not been
established or who is considered to be an undesirable person, e.g., a thief etc. The applicant may be introduced to
the banker in any of the three ways:

        i) A respectable person-either a customer of the same branch of the bank or who is known to the staff of the
branch introduces him by signing on the application form itself along with his full address.

        ii) The applicant may give the name of any respectable person or that of another bank as referee. The banker
enquires from the said referee about the integrity, honesty, respectability, and financial standing of the applicant and
his past experience in dealing with the applicant. If the referee sends no reply, the banker should not open the
account unless satisfactory introduction is given otherwise.

       iii) The Reserve Bank has advised banks that pay books or postal identification cards or identity cards of
armed forces/police/government departments or passport may be considered sufficient for establishing the identity of
person desiring to open deposit accounts without cheque facility.

Risks in Opening Accounts Without Proper Introduction:

         The applicant must be properly introduced to the banker. If the later open an account without proper
introduction or shows carelessness in this regard, cases of fraud or mis-representation may occur frequently. Not only
the banker runs the risk in such cases but the general public may also be received by undesirable customers. The
risks inherent in such cases are as follows:

          i) The banker cannot avail of the statutory protection: Section 131 of the Negotiable Instruments Act provides
statutory protection to the banker, if he collects cheque, bill etc., on behalf of a customer who has no title thereto or
his title is defective. The collecting banker will incur no liability to the true owner of the cheque provided the former
has acted in good faith and without negligence. The banker cannot avail of this statutory protection if he opens an
account in the name of an undesirable person without proper introduction and such person sends a stolen or forged
cheque for collection and he banker does so, because his failure or carelessness to find out the true identity of the
customer will constitute a negligence on his part. If such undersirable persons are permitted to open accounts in the
names of somebody else and they realize the stolen or forged cheques through such accounts and later on disappear
the banker remains liable to the true owner.

         ii) Risk is case of overdrafts: If a banker grants an overdraft, even by mistake or by negligence, to a customer
who is not properly introduced, he bears the risk of loss incase it is not repaid by the customer. The banker remains
unaware of the assets of such customer.
         iii) Risk in case of undischarged insolvent: In case of persons who are declared insolvent, all assets or funds
are attractable, until or unless he is discharged. The deposits received by a banker from an undischarged insolvent,
without proper introduction carries the risk of attachment.

        iv) Risk in case of issue of bogus cheques: If a banker provides a cheque book to an undesirable customer
not properly introduced, there is the risk that be might defraud the general public by issuing bogus cheque on his
account without having sufficient balance.

         The banker must, therefore, seek proper introduction of the applicant for opening a current account, because
all the above – mentioned risks may be faced by a banker in a case of current accounts. The banker may not insist on
introduction if the applicant applied for opening a savings account where only cash operations are permitted because,
neither a cheque book is issued to him not is the permitted to deposit cheque etc., for collection or to take overdrafts.
But in other cases proper introduction is necessary. No introduction is necessary in case of opening a fixed deposit
account for the same reasons.

Introduction : Case Laws

         i) Savory & Company V.LLoyds Bank Ltd., (1932): Two dishonest stock broker clerks in the employment of
the plaintiff firm stole bearer cheque belonging to the employers and drawn payable to third parties. One clerk was
having an account in his own name and the other in his wife’s name. These cheques were paid in at the city offices of
the Lloyds Bank for crediting the accounts kept at country branches. The plaintiff brought an action against the bank
for conversion.

        In the case of the clerk’s account, it was held the bank had been negligent in not obtaining his employer’s
name, when opening the account. In the case of the wife’s account it was held that the bank was negligent in not
obtaining her husband’s occupation and employer’s name at the time of opening account.

        2) Marfani & company Ltd. V Midland Bank Ltd. (1968) : The office manager of the plaintiff company
introduced himself to a restaurant proprietor as open Eliaszade stating, the he was about to set up restaurant. He
gave the name of the proprietor of the restaurant as one of two referees. The he drew a cheque for Rs. 3,000 payable
to Eliaszade, a creditor of Marfani, and got the signature of Marfani. This cheque be paid into his account with the
Midland Bank, which he opened in the name of Eliaszade. The restaurant proprietor, himself a good customer of the
bank indicated that he had known Eliaszade for some time and believed that he was about to set up as restaurateur.
The bank there upon issued a cheque book and in about a fortnight the balance of the account was withdrawn.

        After discovering the fraud Marfani sued the bank for conversion of the cheque. The company alleged that the
account was opened without making sufficient enquiry. It was held that the bankers adopted a normal banking
practice and complied with the standard of care expected of a prudent banker. Therefore the banker could not be
charged with negligence.

         3) Lumsden & Company V. London Trusty Savings Banks (1971) : In this case both the applicant and the
referee were supposed to be professional men, who arrived recently from Australia. The bank was held negligent for
not verifying the customer’s passport and to enquire further about the referee who failed to give his banker’s name.

         The protection given to the collecting banker is conditional and is available only when the collection is made
“without negligence”. But from the above cases it is clear that it is not enough if care is taken merely at the time of
collection. The bank has the obligate to take care from the vary beginning of the relationship at which stage,
information should be obtained not only about the character of the customer but also the name of employer and such
other details which are relevant for the banker, to ensure that the account is not misused for obtaining the payment of
cheques, fraudulently converted to his own benefit. The decision in Marfani’s case in favour of banker should not be
regarded as relaxation of the earlier position on the point. This decision should not encourage the banker to be less
careful in opening the account.

        What should be the contends of a proper introduction and what is the duty of the banker in this regard was
considered by the Madras High Court in Indian Bank Vs Cathoic Syrian Bank (1980 TN Law Notes Journal p. 23). In
this case the applicant for opening a current account was introduced to the bank by a well known customer of the
bank. But what he did was to take the applicant to the bank and informed the branch manager that he was a man
from Indore and that be wanted to open a bank account to enable him to purchase carpets at that place. The
introducer had to give an assurance that the applicant was known to him or that they had long standing business
association and that was a bond-fide customer and account could be safely opened in his name.

        The High Court therefore held that the bank was negligent in securing proper introduction of the applicant. In
the circumstances of the case, bank ought to have made more enquires than usual to test the credentials of the
prospective customer before allowing him to open an account.
       It may be concluded from the above, that the banker should fully ascertain the true identity of the applicant by
other means also, and should not depend exclusively on the causal words of the introducer.

Forms used in the Operation of Account

        Immediately after opening the account the customer is supplied free of charge with the following:

            i)       The Pay-in-slip
            ii)      The Cheque Book and
            iii)     The Pass-book

        i) The Pay-in-slip Book: Every deposit made by the customer in cash or cheques or bills must be
accompanied by this book. This book contains lips with perforated counterfoils. Separate slips are to be made out for
cash and cheques. Some banks have devised different forms, while others made use of the same form with
provisions for both. The form is to be filled by the depositor and the bank after receipt of the cash or cheques, puts the
date-stamp and the counterfoil is initiated by responsible officer and serves as a record for the customer. It is also
preferable for the customer to record on the back of the counter foil the source of receipt so that he will be in a
position to explain the credits in the Pass Book to the Tax Authorities. The slip retained by the banker becomes the
basis for making necessary entries in the ledger.

ii) Cheque Book: It consists of 10 or 20 blank forms. As per the rules and regulations the cusotemr is expected to
draw the cheques only in the forms provided by the banker. Cheque Books are given in recent years to saving bank
account holders also but on the condition they should maintain a minimum balance of Rs. 100. Persons unwilling to
maintain such balance can make use of withdrawal forms from the banker. Such withdrawals are permitted only after
producing the pass book. Cheque books are issued only on the basis of a requisition slip. Every cheque book
contains one such a slip to facilitate the customer to obtain new book before the old one is exhausted. To prevent the
misuse of cheque forms the banker enters the amount number on each cheque and book is issued only after
obtaining the signature of the customer.

        iii) Pass Book: A pass-book is nothing but a copy of the account of the customer as it appears in the bank’s
ledger. All the amounts deposited are credited and the cheques paid against the account are debited. The balance is
shown from time to time.

Closing of a Bank Account

        The relationship between a banker and his customer is a contractual one and continues as long as both of
them so desire. The relationship may be terminated by either of them by giving notice of his intention to the other
party. Moreover, the banker is bound to suspend payment out of the customer’s account under the compulsions of
law. The rights and obligations of a banker in this regard are as follows:

         1. If a custoerm direct the banker in writing to close his account, the banker is bound to comply with such
direction. The latter need not ask the reasons for the former’s direction. The account must be closed with immediate
effect and the customer be required to return the unused cheques.

       2. If an account remains unoperated for a very long period, the banker may request the customer to withdraw
the money. Such step is taken on the presumption that the customer no longer needs the account. If the customer
could not be traced after reasonable effort, the banker usually transfers the balance to an “Unclaimed Deposit
Account”, and the account is closed. The balance is paid to the customer as and when he is traced

        3. The banker is also competent to terminate his relationship with the customer, if he finds that the latter is no
more a desirable customer. The banker takes this extreme step in circumstances when the customer is guilby of
conducting his account in an unsatisfactory manner, i.e., if the customer is convicted for forging cheques or bills or if
the issues cheques without sufficient funds or does not fulfill his commitment to ay back the loans or overdrafts, etc.
The banker should take the following steps for closing such an account:

        a) The banker should give to the customer due notice of his intention to close the account and request him to
withdraw the balance standing to his credit. This notice should give sufficient time to the customer to make alternate
arrangements. The banker should not, on his own, close the account without such notice or transfer the same to any
other branch.
         b) If the customer does not close the account on receipt of the aforesaid notice, the banker should give
another notice intimating the exact date by which the account be closed otherwise the banker himself will close the
account. During this notice period the baker can safely refuse further credit form the customer and can also refuse to
issue fresh cheque book to him. Such steps will not make him liable to the customer and will begin consonance with
the intention of the notice to close account by a specified date.

         The banker should, however, not refuse to honour the cheques issued by the customer, so long as his
account has a credit balance which will suffice to pay the cheque. If the banker dishonour any cheque without
sufficient reasons, he will be held liable to pay damages to his customer under Section 31 of the Negotiable
Instruments Act, 1881.

       c) In case of default by the customer to close the account, the banker should close the account and send the
money by draft to the customer. He will not be liable for dishonouring cheques presented for payment subsequently.

        4. On receipt of the notice of death of a customer, the banker must stop the operation of his account because
the authority of the customer terminates as the dies.

       5. If a banker receives a notice regarding the insanity of his customer, he is bound to stop payments from his

        6. The relationship between the banker and his customer is also affected if the customer becomes insolvent
or the corporate customer goes into liquidation. The credit balance of the customer is transferred to the Official
Receiver of the insolvent customer.

        7. On receipt of a Garnished Order from the Court, the banker is bound to suspend payment from the account
of the customer. If the order prohibits the payment of a specified sum from the account, the banker may honour the
cheques out of the remainder amount.

         8. When the banker has received a notice of assignemtn of the credit balance in the account of a customer to
a third party, the banker is bound to pay the same amount to the said third party.

                                                        Lesson – 19

                                              Different Types of Customers

          A banking institution solicits deposits of money from the members of the public. An account in a bank for this
purpose may be opened by any person who (i) is legally capable of entering into a valid contract, (ii) applies to the
banker in the proper manner, i.e., he follows the procedure laid down by the banker and accepts the tersm and
conditions stipulated by the latter. The banker, however, possesses the right to reject an application for opening an
account, if he is not satisfied with the identity of the applicant, i.e., if the latter is deemed to be an undesirable person.
Some persons like the minors, lunatics and drunkards are not competent to enter into valid contracts. Some persons
who act on behalf of others have limitations on their power to contract, e.g., the agents, trustees, executors etc.,
Institutions like schools, colleges, clubs, societies, and corporate bodies are the impersonal customers of a banker.
The authority power and functions of the persons managing these institutions are embodied in their respective
constitutions. The banker should, therefore, take special care and precautions to ensure that the accounts of these
institutes are being conducted in accordance with the provisions of their respective charters. The present chapter
discusses the legal position of the special cases of a bank’s customers and the necessary precautions that a prudent
banker should take while dealing with them.


         A person under the age of 18 years is a minor, if a guardian of his person or property of both has been
appointed by a Court or if the superintendence of his property has been assumed by a Court of Wards before the
minor assumed the age of 18 years, he remains minor till he completes the age of 21 years (Section 3 of the Indian
Majority Act, 1875). A minor has certain disabilities and enjoys certain protections under the law which a banker must
take into consideration when dealing with a minor.

          Under the Indian Contracts Act, all contracts by minors are void ab-initio excepting contracts for necessaries
of life such as food, clothing and accommodation or for his benefit. The law imposes an obligation on a minor to pay a
reasonable sum for goods and services supplied to him at his request, if the goods are appropriate to his need at the
time, having regard to his means and social standing. His estate becomes liable for contracts in respect of his
necessaries and other benefits. In case of all other contracts a minor may repudiate his promise or contracts. As
minor have limited contractual powers, a banker should take the following precautions in dealing with them:

         i) Opening the Account: Banks prefer to open a saving bank account and a fixed deposit account of a
minor, and would not open his/her current account. There is no risk in dealing with a minor so long as his account is
kept in credit and is not permitted to be overdrawn because any dealing in the form of a loan of money to the minor
would be void. The baker obtains a good discharge in paying cheques and can effectively debit them to the minor’s

        A bank account in the name of a minor may be opened in one of the following ways:

        a) in the name of the minor himself/herself with the consent of his/her natural guardian;

        b) in the joint names of the minor and his/her guardian; or

        c) in the name of the minor under the natural guardianship of his/her father, and if he is dead, under the
natural guardianship of mother, and if both are dead, under the guardianship of a person appointed by a competent

         In cases (a) and (b) above, minor must be aged 12 years or more and should be able to read and write
English, Hindi or a regional language; he should appear competent to transact business. No difficulty is likely to arise
in allowing the money to be withdrawn before the minor comes of age; he could not claim the money over again on
attaining his majority. Un-doubtedly, a branch manager would be very circumspect in allowing withdrawals of
substantial sums to him. Further, a banker will treat a joint account in the name to a minor and his guardian as any
other joint account except that he must bear in mind the non-liability of the minor for any overdraft. In cases (b) and
(c), only the guardian of the minor operates on the account during the period of minority.

         ii) Date of Birth: The date of birth of the minor, as stated by his guardian, is recorded by the bank. On
attaining majority, the minor’s account under the guardianship should be closed and transferred to a new account in
the sole name of minor (who had become major). In case (c) the minor on becoming major is permitted to operate
upon the account and his specimen signature is taken for bank record.

         iii) Loan to a Minor: Money lent to a minor cannot be recovered from his even after he attains his majority.
Any agreement by a minor to repay money lent or to be lent is absolutely void, so also is agreement made after
majority is attained to repay loan contracted during minority, If a bank makes a loan to a minor or permits him to
overdraw his account even by mistake or unintentionally, it cannot recover the amount advanced or interest thereon,
by suing the minor, even if he has fraudulently misrepresented himself as being of full age (R Leslie Ltd. V. Sheill
1814). Consequently, any security given by the minor for the advance is void and the bank cannot retain or realize
securities deposited by the minor. If a third party lodges securities of his own to secure the indebtedness of a minor,
the deposit would be void and the depositor can claim the securities without paying of the amount secured. There is,
of course, nothing to prevent a minor from repaying a loan of his own free will, and once he has done this, he cannot
demand for the return of money.

         iv) Guarantees: No minor can give a valid guarantee nor borrow against the guarantee of an adult because
such a guarantee cannot be enforced on the legal principle that there cannot be a surety without a principal debor. As
the minor cannot make himself liable as principal debtor, so the intending guarantor cannot make himself liable as
surety for him.

        In Manju Mahadeo V. Shivappa Manju (1918) and Pestonji Mody V. Meherbai (1928), the Bombay High Court
held that under section 128 of the Contract Act, 1972, the liability of the surely is co-existence with that of the principal
debtor; it can be no more than the principal debtor; and that the surely, therefore, cannot be held liable for a
guarantee given for default by a minor. If a minor cannot default, the liablility of the guarantor, being a secondary (and
not a primary) liability does not arise at all. The same view was taken by the Madras High court in a case, Edavan
Kellappa Nmbir V. Moolanki Raman (1957).

        However, if lending to a minor does take place, the bank usually takes an indemnity from an adult. Under an
indemnity the adult takes primary liability for the debt which means he/she is responsible for it, as compared with
secondary liability under the guarantee where he/she is only responsible if the borrower fails to repay the debt. Thus,
an intending surety can be made liable as an indemnifier under a contract of indemnity whether included in the
guarantee or subject of a separate document. Unless the bank’s form of guarantee includes an indemnity, a specific
indemnity should be taken from the surety.

         v) Minor as a Party to a Negotiable Instrument: Under Section 26 of the Negotiable Instruments Act, 1881,
a minor may draw, endorse, deliver and negotiate negotiable instruments so as to bind all parties except himself,
such bills or cheques will be valid instruments and other parties will be liable in their respective capacities. For the
banker, this means that the minor by law having no capacity to contract, cannot be sued on any cheque that he may
draw and that if he exchanged a cheque for a minor he cannot recover the proceeds if the cheque is afterwards
returned to him dishonoured. However, by making payment to a minor of his own cheque or of third party cheque, if it
is otherwise a payment in due course, the banker gets a valid discharge. A minor cannot be sued in respect of a bill
accepted by him during his minority.

          vi) Minor as a Partner: A minor can be admitted to the benefits of partnership with the consent of all the
partners but he will not be liable for losses and debts of the firm. According to Section 30(7) (a) of the Indian
Partnership Act, 1932, unless, a minor expressly reputidiates his liability within six months after becoming of age, he
would be held liable as a partner from the date he was admitted to the benefit of the partnership. Should the minor
avoid his partnership contract, the adult partner is entitled to insist that the partnership assets be applied to the debts
of the firm, and until they are provided for, no part of the asset may be received by the minor.

        viii) Minor as an Agent: A minor may be appointed to act as an agent on behalf of his principal. In this
capacity he may draw and sign cheques on his principal’s account and if the account becomes overdrawn as a result,
the principal will be liable because the agent stands in his place and the acts properly done by him are considered to
be the acts of he principal. The banker should obtain written authority of the principal specifying the power and the
extent of the authority entrusted to the agent and should see that the minor-agent does not deal beyond the delegated

         ix) Minor as a Witness: A minor can legally witness a signature if he is old enough to appreciate the
significance of his act.

        x) Safe Custody Articles: Mr. and Mrs. B are joint account customers who have deposited for safe custody
among their various holdings National Savings Certificated purchased by them in the name of their minor son who, on
reaching the age of 18, requests the bank to deliver the certificated purchased in his name to him claiming that he is
the true owner. Although on the face of it the true owner of the National Savings Certificates is the person in whose
name they were purchased, these are held in safe custody on behalf of Mr. and Mrs. B whose discharge alone is
acceptable to the bank.

        xi) Stock and Shares: A banker should neither accept from a customer an order to purchase stock or shares
in the name of a minor, nor should be sending to the company stock and shares for registration of transfer in the
name of a minor without informing the company that the transferee is a minor. A minor is not legally capable of
implementing a contract of purchase, or accepting the stock or shares when purchased.

        A transfer to a minor is voidable at his option, and he cannot compel the company to register him as a
shareholder, nor if he has been registered, to keep him on the register when the company discovers that he is under
age. A transfer by a minor can be validity executed only in pursuance of an order of the court. There is, however, no
objection to a transfer into the joint names of an adult and a minor. Where stock is standing in the joint names of a
minor and an adult, a letter of attorney for the receipt of the dividends may be given by the adult.

Joint Account

        When two or more persons open an account jointly, it is called a joint account. Such accounts may be opened
by any two persons for the sake of convenience of operation of account and also for withdrawal of money after the
death of any one of them. The banker should take the following precautions in opening and dealing with a joint

        a) All persons should sign the application for opening the account.
        b) The banker should ascertain the style under which the account is to be opened.
        c) The nature of account must also be ascertained
        d) He must ascertain the mode of operation of the account. In this connection he must note that the authority
given to any one of the joint account holders to operate the account does not extend to withdrawals of articles
deposited for safe custody, does not make one party liable for overdrafts taken by another, and does not cover
dealings in bills and securities. Therefore, he must get clear instructions regarding these matters.

        e) In the absence of specific instructions the cheques must be signed by all the joint account holders. In order
to secure his position the banker must obtain a clear mandate from the persons desiring to open a joint account. This
mandate must be signed by all the persons which must contain the following particulars.

Accounts Mandate

A. Drawings

        The mandate must state the name of persons who are authorized to draw cheques on the joint account. In
the absence of such clear instructions he must honour only the cheques which are signed by all. The ordinary rule
regarding joint debts is that payment by a debtor to open of the several joint creditors, is a good discharge against all,
provided hat the debtor was unaware of any lack of authority on the part of the creditor in question. This, however,
does not apply to debts due from bankers. A banker, as a debtor of his joint customers, does not get a good
discharge unless he pays the debts with the consent of all.

        However, the authority given to anyone terminates on the death, insolvency or insanity of any one of the joint
account holders. In addition to this cheque drawn by any one on the authority given by others may be countermanded
by any one of them.

B. Survivorship

        The mandate should also deal with the question of survivorship. This is not however necessary since under
the law of devolution application to joint owners on the death of any one of them the survivors are entitled to the
balance standing to the credit of the account. Therefore the executors of the deceased cannot claim a share in the
balance. But in order to avoid future disputes the application to open the joint account contains the clause “In the
event of death, insolvency or withdrawal of any of us, the survivor or survivors of us shall have full control or any
moneys then and thereafter standing to our credit in our account with you”.
C. Power to overdraw

         The mandate must also contain the names of persons who are authorized to overdraw on the joint account. In
such a case in addition to the joint liability, several liability also must be included. This, however, does not arise in
India, since Under the Indian law, liability by more than one person is joint and several. If shares in the joint names
are pledged as the security for loans, transfers must be effected by all of them.

D. Other Matters

        The mandate must state whether power is given to any of them to withdraw securities and other items
deposited for safe custody.

        Death of one of the Joint-Account Holders: If the account is in credit the rule of survivors, applies. But the
banker should obtain a fresh mandate, from the remaining survivors, this is because death cancels the mandate.

        In case of debit account, the banker should close the account prevent the operation of rule in Clayton’s case
to determine the liability of the deceased’s estate.

         With regards to safe custody articles as the law is not certain, it is safe for the banker to part with them on the
receipt executed by survivor and the representatives of the deceased party.

         Insolvency of one of the Joint-Account Holders: The operation of the account must be stopped immediately
after the receipts of notice of insolvency. If the balance is in credit, the amount can be released on the joint authority
of the solvent party (or parties) and the official receiver. In the case of debit balance also the account must be
stooped to determine the liability of the insolvent’s estate. In the case of safe custody items, they must be delivered
only after obtaining the receipt from the solvent party and the official receiver.

        Rule of Survivorship in the Case of Husband and Wife: All the rules applicable to joint accounts also hold
good in cases where the account is opened in the joint names of the husband and wife. However, as regards the
doctrine of survivorship, there is a lot of controversy. In view of these, the following rules can be lain down which are
applicable only to this type of joint account.

       If the account is opened by the husband for his convenience, the balance in the absence of any written
mandate to that effect, cannot be claimed by the widow, but it is to be transferred to the estate of the deceased
husband. This was laid down in Marshall v. Crutwell (1875).

        If, however, the account is opened with the intention of making a provision for the wife, the balance can be
claimed by the widow who is entitled to get the same and the amount cannot be claimed by the creditors. Foley v,
Foley (1911).

Partnership Firm
         A partnership is not regarded as an entity separate from the partners. The Indian Partnership Act. 1932,
defines partnership as the “relation between parsons who have agreed to share the profits of he business, carried on
by all or any of them acting for all”. A partnership firm is thus established by an agreements amongst the parents. This
agreement may be oral or written. The object of constituting a partnership firm must be to (i) carry on a business
which may be conducted by all the partners or by any of them on behalf of the rest, and (ii) to share the profits of such
business amongst themselves. The partnership deed contains the details of the agreement reached between the
partners. The Indian Partnership Act. 1932, lays down the general provisions which govern a partnership business. A
banker should take the following precautions while opening an account in the name of a partnership firm.

1. Number of partners:

        The banker should very carefully examine the Partnership Deed, which is the charter of the firm, to acquaint
himself with the constitution and business of the firms. The banker should see that the number of partners does not
exceed the statutory limit. According to Section 11 of the Companies Act, 1956, a partnership firm consisting of more
than 10 persons for the purpose of carrying on banking business and of more than 20 persons for the purpose of
carrying on any other business for the acquisition of gain or profit, shall be an illegal association unless it is registered
under the Companies Act., 1956, or is formed in pursuance of some other Indian Law or is a Joint Hindu Family
carrying on such business. If the number of partners exceeds these limits, the partnership becomes an illegal
association of persons, which cannot enter into any contract, and sue or be sued. The minimum number of partners in
a firm must be two, excluding a minor partner, who is not competent to enter into a contract. A minor may be admitted
into the partnership with the consent of all other partners but he shall not be liable for the losses or debts of the firm.
The banker should note the date when the minor partner attain majority so that a fresh partnership letter signed by
him and other partners is obtained by the banker.

2. Title of firm’s Account:

        A form’s account should always be opened in the name of the name of the firm and not in the name of the
individual partner/partners.

3. Opening of an account:

          An account in the name of a firm may be opened by a banker on receipt of an application form one or more of
the partners. Ranks, however, insist that all the partners should join to pen the firm’s account. If any partner has gone
out of the country, the rest of the partners can open a bank account in the name of the firm. Specimen signatures of
all the partners should also be taken for the purpose of record. But if any of the partners is deprived of he right to
open an account in the firm’s name and this fact is within the knowledge of the banker, he should not open the firm’s
account at request of such partner. The banker should, therefore, confirm the right of the applicant/applicants to pen
an account in the name of the firm from the partnership deed or from any other available evidence, e.g. the authority
letter signed by all other partners.

4. The Partnership Letter or Mandate:

        The banker should take letter signed by all partners stating:
        (i) the names and addresses of the partners.
        (ii) the nature of the business undertaken by the firm, and
        (iii) the name/names of the partner/partners who will operate the account on behalf of the firm and will have
the authority to draw and accept bills etc., and to sell and mortgage the property of the firm.

        The banker should honour the cheques signed by all the partners or by those partners who are authorized to
operate the account.

5. Revocation of authority to operate the account:

        The authority given in favour of a particular partner/ partners to operate the firm’s account may be withdrawn
by any of them by giving a notice to the banker. In such circumstance, the banker should stop payment of cheques
signed by all the partners. A partner can also stop the payment of a cheque issued by any other partner on the firm’s

         The power to revoke the authority to operate the account is vested in any partner who is a sleeping partner or
is not authorized to operate the account.

        6. A partner authorized to operate the firm’s account cannot delegate his authority to another person without
the consent in writing of all other partners. If such consent is given by all of them, the authorized partner may execute
a Power of Attorney in favour of such other person.

         7. In a cheque payable to the firm is endorsed by a partner in this own favour and is deposited by him to be
credited to his personal account, the banker should do so after making an enquiry about it form other partners and
after being satisfied about it Otherwise, he will bear the risk of losing the statutory protection granted to the collecting
banker under the Negotiable Instruments Act, 1881. The banker should be particularly careful in this regard if the
partner sends such a cheque in response to a request from the bank to repay overdraft taken by him from the bank.

Implied authority of a partner:

         A partner acts as an agent of the firm for the purposes of the business of the firm and binds the firms by his
acts and deeds. According to Section 19(1) of the Indian Partnership Act., 1932, “the act of a partner which is done to
carry on, in the usual way, business of the kind carried on by the firm binds the firm” This authority of a partner is
called the implied authority. Every partner is liable not individually and jointly with other partners or all the acts of the
firm or the instruments executed provided the some are done:
        (i) in the name of the firm; and
        (ii) in connection with the business carried on by the firm.

        Any partner has an implied power to stop payment of a cheque drawn on the firm’s account and the banker is
bound to comply with the instruction of the partner. So also any one or more partners may cancel the authority given
to operate in the account, and in that case the banker should not honour cheques drawn by such an authority.

        Every partner in a commercial partnership (trading firm) has implied authority to bind the firm by making,
drawing, singing, endorsing, accepting, negotiating and discounting negotiable instrumentas in thename and on
account of the partnership. He has also authority to borrow money. However, the banker shuld not honour cheques or
other instruments signed by a partner whom the bank mandate does not authorize to sign on behalf of the firm. The
power of a partner to borrow is also dependent on the instruments in the mandate.

          A partner in a non-trading firm has no implied authority to borrow or to make to issue negotiable instruments,
although he may sign cheques. Therefore, the banker should get the signature of all the partners in a non-trading firm
for all transactions involving advances to the firm, or the discounting or the negotiating of bills of exchange.

         Another implied authority of a prtner in a commercial partnership is his power to pledge the firm’s properties.
But this implied power is consigned to those transactions incident to the firm’s ordinary course of business. Hence,
the safer course for the banker would be to get the assent of all the partner.

        A partner has no implied power to bind his co-partners by deed. So the banker should see that he gets the
assent of all the partners when immovable properties of the firms are mortgaged as otherwise the banker will get only
an equitable title and not a valid legal title.

It may be mentioned here that the implied authority of a partner to bind the firm does not extend to guarantees. A
partner can not bind the firm by giving a guarantee on behalf of the firm, unless it is customary for that firm, or partner
can not bind the firm by opening an account in his own name on behalf of the firm unless he is expressly authorize to
do so by all the partners. The banker should not accepted for the credit of the private account of a partner cheques
payable to the firm. When such a cheque is presented, the banker should make enquiries. Omission to make
enquiries will deprive a banker of his statutory protection.

        8. When a new partner is admitted to the firm, the banker need not stop the operations in account provided
the account should obtain a new mandate signed by all the partners, including the new partner. But when the
partnership account shows a debit balance, the banker should stop the operations in old account and open a new
account. A new mandate should also be obtained. The banker may take an agreement signed by the new partner
undertaking the liability in respect of the outstanding debts of the firm, balance on the partnership account. The can
give the banker a valid discharge for it. In case the partnership account shows a debit balance, the account should be
stopped to fix the liability of the deceased, and any cheques presented thereafter should be returned with the remark
partner deceased. The rule applies even when the cheques are signed by the deceased partner.

        10. In the event of insolvency of a partner, the solvent partners have a right to operate the partnership
account in connection with the winding-up of the business. However, if the partnership firm is indebted to the bank,
the account should be stopped and a new account should be opened in order to avoid the application of the Rule in
Clayton’s case. The banker should not honour cheques drawn by the insolvent partner. Cheque drawn by him before
adjudging him an insolvent may be honoured by the banker. However it is always advisable to obtain the
confirmation of other partners.

          11. In the caser of retirement of a partner, the retiring partner will continue to be liable to the banker till the
latter is served with a notice of the retirement of the former. On receiving such a notice the banker should take a new
mandate from the continuing member. If the partnership account shows a debit balance, the account should be
stopped in order to avoid the application of the Rule in Clayton’s case.

         12. In the case of lunacy of a partner, the partnership firm does not stand dissolved. However, upon
application of a fellow partner the court may order a dissolution. On such a dissolution the banker may allow the other
partner to continue the account if is shows a credit balance. If, on the other hand, the account shows a debit balance,
the banker should stop the account.

         13. It should be remembered there that alterations in the constitution of a firm will affect any charge which
may have been given on the partnership property. Therefore, the banker should obtain a new mortgage deed signed
by all the new and continuing partners.

Joint Sock Companies

         A joint stock company is a separate legal entity quite distinct from its shareholders, having perpetual
succession and a common seal. So even if only one shareholder holds all the shares, the company is distinct form
such shareholder. Thus in Solomon V. Solomon & Co. Ltd. (1897), the plaintiff was principal shareholder and was
also holding secured debentures for £ 10,000. The unsecured creditors wanted to deprive him of the security on the
plea that he and the company were one person it was held that the company possessed separate legal entity, it was
perfectly legal for Salomon to contract with it and therefore entitled to priority in respect of his security.

      The account opening formalities and the precautions needed in operating the Accounts of Public Limited
companies whose liability is limited by shares are discussed below:

Steps to be taken in Opening an Account

        1) The Banker should ensure that the company is incorporated by looking into the certificate of incorporation
granted by the register of Joint Stock Companies.

        2) The banker should obtain copies of Memorandum and Articles of Association and inspect them carefully
before he established the relation with the company. The banker should also get it duly certified by the Secretary that
the copies are upto-date, since both the clauses in the Memorandum and the Articles can be altered from time to
time. Where the Banker gets any doubt he can inspect these documents in the office of the Register of Joint Stock
Companies. He must not the borrowing powers, powers to give guarantees and other securities and the restriction if
any on director’s powers to borrow.

         3. The banker should also obtain the certificate to commerce business and return the same after recording
the particulars. This is the certificate granted by the Registrar certificate that all formalities have been completed by
the company and the company is entitled to commerce the business.

         4. The banker should also obtain copies of recent balance Sheet and Profit and Loss Account in the case of
an existing company r in the case of a newly formed company a copy of the Prospectus or a Statement in lieu
thereof. If the company is not willing to give the Balance Sheet, adequate details regarding capital, liabilities, assets
and statement of business must be sought.

       5. In the case of a new Company the banker should scrutinize the Articles to see if the first director and
Bankers of the Company are named therein. However it is not common to find these in the articles.

         6. The banker should obtain a certified copy of the resolution of the Board appointing him as a banker of the
company and usually such resolution embodies explicit instructions as to who shall draw cheque, draw, accept and
endorse bills and deal with securities and safe custodies. The bankers should also obtain the specimen signatures of
the officers who are authorized by the resolution to operate the account. Such a copy should be signed by the
Chairman of the meeting and the Secretary of the Company.


         1) The Borrowing Powers of the company must be ascertained with reference to the Memorandum and
Articles. In the case of trading companies the power to borrow is implied. But in the case of non-trading companies,
the power must be specifically stated.

         2. The banker should note particularly the provision in the Companies Act., 1956 that the Board of Directors
of a Pubic Limited Company cannot borrow moneys where the moneys to be borrowed together with the moneys
already borrowed exceed the aggregate of the paid up capital of company and its free reserves, i.e., reserves not set
apart for any specific purpose. In computing the total borrowings, loans repayable on demand and short-term loans
for periods not exceeding six months are excluded. Every time a loan is contracted by the Directors, the banker
should ensure that it is within their powers. Otherwise the consent of company in general meeting should be obtained.
Companies consent is in the form of a resolution and it should state the total amount that can be borrowed by the
directors. Apart form this; the Articles of the company may impose additional restrictions.
       3) Where the borrowing is conducted under the delegation of powers the banker should see that it is strictly in
accordance with the articles. He should also see that the documents are signed giving reference to the resolution.

         4) The banker should see that the borrowing is not ultra-vires the Memorandum i.e. not for the purposes
specified in it. If the borrowing is ultra-vires, it is not binding on the company. In Re-Introductions Ltd., (1969), the
National Provincial Bank lent moneys to Introductions Ltd. for a Pig-feeding scheme beyond its physical objects, but
relying on an “independent borrowing object”. The Court of Appeal held that such an object must be related to other
objects, and therefore the borrowing being ultra-vires, the loan and security are not binding on the liquidator. Even if
all the shareholders approve of it, it cannot become valid. However, where the borrowing is ultra-vires the directors,
but intra-vires the Memorandum such a borrowing can be ratified by a special resolution of the Company.

         5. At the time of winding up, the powers of directors cease except to the extent permitted by the company or
liquidator. The banker after receiving the notice of the resolution for winding up, should not honour cheques issued by
Directors, unless such power is conferred on them either by the company in General Meeting or by the liquidator.
         6. Section 125 of the Companies Act. 1956 gives a list of charges requiring registration. The list of charges is
of special interest to the bankers and when a particular charge is made on the company in connections with the
borrowing he should find out whether it requires registration. The charge must be registered within 30 days from the
date on which it is actually signed or sealed. Failure to register the charge will make the security void as against the
liquidator or may creditor of the company. In addition, subsequent registered charges will have priority over the
unregistered charges, event if the person in whose favour the subsequent charge is created has express notice of the
prior unregistered charge. (In Re. Moolthic Building Company V. Tacon Co.) A registered charge can be cancelled by
sending Memorandum of Satisfactions to the Register.

        Charges Requiring Registration
        a) A charge for the purpose of securing any issue of debentures;
        b) A charge on uncalled share capital of the company
        c) A charge on any immovable property wherever situated, or any interest therein;
        d) A charge on any book debts of the company,
        e) A charge, not being a pledge, in any movable property of the company;
        f) A floating charge on the undertaking or nay property of the company including stock –in-trade.
        g) A charge on calls made but not paid;
        h) A charge on a ship or nay share on a ship;
        i) A charge on goodwill or a patent or a licence under a patent, on a trade mark or on a copyright or a licence
under a copyright.

Procedure for Registration

        The company must file prescribed particulars of the charge together with the copy of the instruments creating
the charge. Whenever a bank gives a loan by creating a change which requires registration, he should see that the
charge is registered within the prescribed period. It is in the interests of the banker to see that the charge is
immediately registered because any person acquiring such property or a part of it or any interest therein is deemed to
have notice of the charge from the date of registration and not form the date of its creation. Therefore, even a
subsequent charge when registered earlier will enjoy priority over the previous charge.

Executors and Administrators

         Executive and administrators are persons who are appointed to conduct the affairs of a person after his
death. When a person knows as testator appoints another person for this purpose through a will, he is known as an
executor. If the will of the testator does not mention the name of the executor, or if the person appointed as executor
dies or refuses to act, the Court appoints a person for the purpose who is h\know as administrator. Both the executor
and the administrator perform the same duties, i.e., to realize the assets of he deceased and to pay of off his debts.
The executor is appointed by the will. His powers and authority are vested therein. He has to act according to the
directions given in the will, but he is required to obtain a probate (official confirmation of the will) from the court. The
administrator is appointed by the court through a letter of Administration and is directed, in the absence of the will, to
settle the affairs according to the provisions of the law. The banker should take the following precautions while
dealing with executors and administrators.

        1. On the death of a customer, the banker must stop payments from his account. The executor should be
permitted to operate the account of the deceased after he has obtained the probate from the Court. The administrator
is authorized to do so after securing the Letter of Administration. The banker should examine these documents before
the appointed person is permitted to operate the account.

       Am account in the name of an executor/administrator is opened in the following style and the balance in the
account of the deceased is transferred to such account.

        “ABC executors (or administrators) to the Estate of XYZ deceased”

         2) In case two or more persons are appointed as executors or administrators, they shall have joint interest in
the estate of the deceased. This interest is not capable of division. One or more executors may draw cheques on the
account but a letter of authority signed by all of them, stating the name. Names of the persons who will operate the
account, is taken by the banker. If this authority is revoked, either all of them should operate the account jointly or a
fresh letter of authority is given to the banker. Any of the executors/administrators is competent to countermand the
payment of the cheque issued y any other executors/administrator.

        3. The banker should be very cautious in conducting the account of executors/administrators so as to prevent
them from misappropriating the funds of the deceased. The banker should not permit transfer of funds from the estate
account to the personal account of the executor to repay an overdraft taken by the executor. Similarly the banker
should not have recourse to the securities belonging to the deceased for granting personal loan to the executors.

        4. In case of death of one of the executors or administrators a cheque issued on such account should not be
dishonoured even if he is one of he two or more joint signatories, because on the death of one of he executors
(unless otherwise provided in the will) or of an administrator, his powers are vested in the surviving executors and
administrators. Of course, in such cases a new Letter of Administration is to be secured from the Court.

        5. The banker cannot exercise his right of set-off against the credit balance in the executor’s personal account
in respect of a debit balance in the account of the deceased.

       6. If the executor requires an overdraft or a loan before he obtains the probate in order to make necessary
payment, the banker usually advances such loans on the personal security of the executor, so that he can recover the
same in case the probate is not granted. The executors are made jointly and individually liable for such loans.

        7. After the court grants probate or issue a Letter of Administration, the executor or the administrator may
pledge specific assets of the testator to obtain an overdraft from the banker. But if the will specifically forbids such
powers, the executor cannot do so. The banker should therefore, very thoroughly examine the will to ascertain the
borrowing power of the executors. In case a loan is granted, all the executors must sign the documents. The
executors may also make themselves personally liable for such loans.


         A trustee is a person to whom property is entrusted so that he may deal with it in accordance with the
directions given by the creator of the trust, a person he can trust to carry out his wishes honestly and efficiently. The
person setting up the trust is called donor or author of the trust. Those who are to benefit under it are called
beneficiaries. The document by means of which a trust is usually formed is called the “Trust Deed”. The law relating
to trusts is contained in the Indian Trust Act. 1882.

         There is a wide variety of trusts in operation in this country today. They may be categorized into i) private
trusts, and ii) corporate trusts. The distinction is not clear cut as, for example, some trusts such as charitable trusts
are hybrid in the sense that they fall into either category. Private trusts fall into two broad categories-those which arise
under a will and those which are made inter vivos (i.e, those made by deed in donor’s lifetime).

         A trustee could be a friend or relation, a solicitor, or a corporate trustee such as a bank. Trusts are found in
different capacities. A common example is where a man sets up a trust for the benefit of his children. To do this he
has to choose a trustee and give over to him the securities which from the trust property. As the securities produce
interest at regular intervals, the trustee pays the money out to the children in accordance with the terms of the trust
instrument. Perhaps the most familiar form is a trustee in insolvency (bank-ruptcy under English law) whose task is to
take charge of the assets of an insolvent, turn them into money, and then apply that money as far it will go in settling

the debts. Another is a trust under the deed of arrangement which is a kind of alternative to insolvency, if the creditors
will agree to it. The trustee administers the property of a debtor for the benefit of the creditors.

        Before opening an account in the name of a trust, the banker should examine carefully the Trust Deed and
ascertain such matters as the power of the trustee to delegate their powers to any one or more of them, their power to
borrow money and the manner of operating on the account in case of death or insolvency of a trustee. It may be
noted here that unless the Trust Deed given authority to the trustees to delegate their powers, they cannot do so.
Consequently, in the absence of an express provision in the Trust Deed to the contrary, the banker should honour
only such cheques as are signed by all the Trustees.

        Even when an account is opened not describing it as a trust account, if the banker comes to know that it is
trust account, he should not allow the customer to draw out money for a purpose obviously inconsistent with the
customer’s duty as a trustee. However, his does not mean that the banker should act as a detective.

         Where a customer has more than one account, the banker need not necessarily presume that one of them
may be a trust account. In some cases, the very title of the account itself may indicate that it is a trustee account.
Certain other titles may not describe the account as a trustee account. In such cases if the banker has information
that the account is a trust account, he cannot escape liability merely on the ground that there was no indication of the
fact in the title of the account. For instance, the opening of an account under the title ‘Kumar Ghosh’ does not
describe the account as a trust account. It only shows that the account is a private account with reference to a
particular transaction with Ghosh. However, the banker should pay regard to the circumstances, or to any information
showing that the account is a trust account. Again, the opening of an account under the title ‘Kumar per Ghosh’ does
not necessarily describe the account as a trust account. It may mean an account belonging to Kumar consisting of
funds brought in by Ghosh. Nevertheless, if the title means that the account has been opened by Kumar to be drawn
on by Ghosh, then it is a trust account.

       It was held in John V. Dodwell (1928 A.C. 563) that if a customer had one bank account in his personal name
and another in the trust name, a transfer of money from the trust account to the personal account should put the
banker on enquiry. This is particularly important when the transferee account happens to be overdrawn. The banker
would be held liable for breach of trust, if it could be proved that the banker derived some benefit out of the transfer.

        The banker should not credit to the trustee’s private account cheques drawn in favour of the trust. Again the
banker is not entitled to use his right of set-off between the trustee’s private and the trust account. But if he has no
notice of the character of the accounts, he may exercise his right of set-off. Further, the banker should not grant an
advance on a trustee’s private account against trust securities.

         Unless the Trust Deed gives to trustee express powers to borrow and pledge the trust property, the banker
should note that he is not entitled to borrow money or give any security. But if the Deed gives express powers to the
trustee to borrow money by mortgaging trust property, he may do so.

        On receipt of the notice of the death of one of the trustees, the banker should ascertain fro the Trust Deed
whether or not the surviving trustees are entitled to act without the appointment of a new trustee. If a new trustee is
required, the banker should suspend all operations on the account until a new trustee is appointed.

        Where a trustee becomes an insolvent, it does not involve the trust property. The trust property belongs to the
beneficiaries, and the private creditors of the trustee have no right to claim it. The trustee’s right to deal with the trust
property, for the purpose of trusteeship, is also not affected unless the Trust Deed provides otherwise

       On receipt of the notice of the insanity of a trustee operation on the account by that trustee should be

Clubs, Societies and Charitable Institutions

          Clubs, societies, charitable and religious, institutions, libraries, schools, colleges, etc., not engaged in trading
activities, maintain their accounts with the banks. The bank should observe the following precautions in dealing with

        i) The Society must be incorporate: The Societies Registration Act. 1960, provides for the registration of
societies for the promotion of literature, science, fine arts or for charitable purposes. Such institutions may also be
incorporate under the Companies Act, 1956, or the Co-operative Societies Acts. A society gets the legal recognition
as an entity separate from its members only after its incorporation under any of these Acts. Thereafter, it is
empowered to enter into valid contracts and to sue or be sued. The banker should, therefore, ensure that the
applicant society is a properly incorporated body. The unregistered society cannot be sued in law.

         ii) Rules an by-laws of the Society: A registered society is governed by the provisions of the Act under which it
ha been registered. It may have its own Constitution, Charter or Memorandum of Association and rules and by-laws,
etc., to carry on its activities. A copy of the same should be furnished by the society to the banker to acquaint the
latter with the powers and functions of the persons managing its affairs. The banker should ensure that these rules
are observed by the persons responsible for managing the society.

        iii) Resolution of the Managing Committee: For opening bank account, the Managing Committee of the
society must pass a resolution.
        a) Appointment the bank concerned as a banker of the society;

        b) Mentioning the name/names of the person or persons, who are authorized to operate the account; and

        c) giving any other direction for the operation of the said account.

        A copy of the resolution must be obtained by the bank for its own record.

        iv) Borrowing Power of the Society: In case a registered society intends to borrow, the banker must certain
the borrowing power of the society from this charter or Memorandum. The purpose for which such borrowing is
permissible must also be noted and the powers of the managing committee or its office-bearers to create a charge
over he assets of the society for the purpose of borrowing should be enquired into. A resolution must be passed by
the Managing Committee for this purpose and a copy thereof must be sent to the banker.

        v) Death or Registration: In case the person authorized to operate the account on behalf of a society dies or
resigns, the banker should stop the operation of the society’s account till the society nominates another person to
operate its account.

         vi) Care to be exercised in case of Persona Accounts: If the person authorized to perate the society’s account
is also having his personal account with the same branch of the bank, the banker is under an obligation to ensure that
the funds of the society are not being credited to the personal account of the said person or officer-bearer. For
example, the Principal of College is authorized to operate the account of a College with Bank X. He also has his
personal account with the same bank. He sends to the bank for collection and credit to his personal account a cheque
drawn by a donor in favour of the College The banker is under an obligation to ensure that he receives payment in
behalf of the true owner of the said cheque, i.e., on behalf of the college. If he fails to do so he will be held guilty of
negligence and shall not be able to avail of the statutory protection under Section 131 of the Negotiable Instruments
Act. In these circumstances, the banker should not collect such cheque for crediting the same to the account of the


                                                       Lesson - 20

                                                Customer’s Pass Book

         Pass book is a handy small account book, issued by the banker to a customer, to record all dealings of
receipts and payments between them. It contains an exact copy of the account in his banker ledger and is so named
because it passes frequently to and fro between the banker and the customer. The object of a pass book is to inform
the customer from time to time the condition of his account as it appears on the books of the bank. It not only enables
him to discover errors to his prejudice but also supplied evidence in his favour in the event of the litigation or dispute
with the bank. In this way it protects him against the carelessness or fraud of the bank.

        Some big banks send to the customers a statement of their account periodically, i.e., fortnightly or monthly,
instead of a pass book. The pass books are always handwritten. When statements of accounts are given, some
banks get them prepared on machines. The statement of account, in the absence of any judicial decision, stands on
the same footing as the pass book:

        A pass book may take any of the following forms:

In Account with the …………………… Bank Limited
Folio …………….                      A/c No………….
         Date         Particulars                                Withdrawal      Deposits     Balance    Initial
                                                                          Rs.           Rs.        Rs.
         1991            By Cash                                                       500        500
         June 20
         July 4          To X (Cheque No. 55861)                          150                     350
         July 6                                                                        850        1200
         July 12         To (cheque No. 5562)                             350                     850
         July 15         By Cash                                                      1250        2100
         July 16         To M (Cheque No. 55864)                          100                     2000

In Account With the % ……………………….. Bank Limited
Folio…………………….                       A/c No………..
Dr.                                          Cr.
         Date           Particular        Rs. Date                              Particular               Rs.
          1961                                                1961
          July 4           To X      (cheque     No.   150    June 20           By Cash                  500
          July 12          To Y      (cheque     No.   350    July 6            By Cheque (55862)        350
          July 16          To M       (cheque     no   100    July 15           Bills collected          1250

Completion of Pass Book

        The following points are relevant and of importance in the completion of the pass books:

        i) Entries in the pass book should be made in the hand of only bank officials. The customer should not be
allowed to make any entry in the pass book himself, even for the purpose of reconciling the account.

        ii) A pass book should be written only after the credit ad debit entries had been posted in the ledger and not
before. There is then, little likehood of a mistake passing unnoticed.

        iii) A pass book when sent out to a customer must show up-to-date entries and if he alters his positions on
out-of-date information, he certainly has a cause of grievance against the bank.

       iv) In those cases in which alternations are necessary, the wrong figures should be ruled through and correct
one neatly written above. Scratching out a penknife or an erasure should never be permitted.

        v) If the pass book is lost by the customer and he requests for a duplicate one, a duplicate pass book should
be issued by the banker and marked “Duplicate” free of charge or at a small charge varying with the work involved. A
note to the effect that a duplicate pass book has been issued should be given on the relative ledger folio and in the
even of the original turning out again, the account holder should return in to the bank.

         vi) In the case of savings bank accounts, bank rules provide that the pass book must accompany the
withdrawal form every time the money is withdrawn through the withdrawal from. The pass book should be completed
and returned to the account holder there and then instead of detaining it in the bank and returning it later even though
there is just one entry to be made therein.

         The attributed of a good pass book are accuracy and neatness. A shabbily written pass book is apt to create
for the bank an undesirable reputation for carelessness. Nothing looks more contemptible than a pass book in which
alternations and overwriting are both numerous and badly made. It would be appropriate to reproduce here the
observations and recommendation of the Banking Commission (1972) which are as relevant today as when they were
made sixteen years ago.

         “The statements of accounts and pass books should be written neatly, legibly and accurately and furnished to
the customer promptly. Considerable difficulty is experienced by banks when the pass books are presented by
savings bank account holders who are allowed to make withdrawals by cheques for being brought upto date after
long intervals and cones-quently the return of pass books to customer is delayed. Banks should therefore, discontinue
the issue of pass books to such account holders and instead furnish them with statements of accounts say at bi-
monthly intervals. The banks which still issue pass books to current account depositors should alsowitch over to the
system of furnishing statements of accounts “. (Report of the Banking Commission, Government of India, 1972, p.

         Undoubtedly, some customers are very careless in the matters of sending the pass books to the bank to be
written up, as observed by the Banking Commission Again, some others leave the book at the bank and do not care
to see it from one year’s end to another. Both classes of customers should be asked to have their pass books
completed at least once a month, so that the balance may be agreed. For this purpose, it would be necessary for the
bank to keep a check on the movements of pass books through a Pass Book Register in which all pass books
received and given out must be entered under the respective dates which should be authenticated by a responsible
officer of the branch.

        Whether Pass book can be relied on as a Settled Account.

         When the Pass Book is submitted to the customer it amounts to a statement of account rendered by the
banker. If the customer agreed to this it becomes an “account settled”. Probably based on similar thinking. Mr. Paget
says, “its proper function is to constitute a conclusive and unquestionable record of the transactions between banker
and customer and it should be recognized as such”. Ti is also implied in the case of an account stated, that the
balance will be paid as a lump sum by the party agreed to be in debt without reference to the individual items. When
an account has once been stated, the individual items become merged in the final balance and can no longer be used
upon individually.

         However, according the law in England and India, pass-books are not so well settled, accounts as stated in
the earlier paragraph. In many cases the pass-book is not accepted as an account settled. Thus the law is
unsatisfactory from the view-point of bankers. But it may be worth-mentioning here that in America it is obligatory on
the part of the customer, to examine the pass-book and vouchers and to report to the bank without any unreasonable
delay any errors which may be discovered.

        Now we shall consider the position of the banker and customer in relation to entries made in the pass-book.
This can be studied by dividing such entries into those favourable to the banker and those favourable to the customer.

Entries in Customer’s Favour

          The account of a customer may sometimes show a wrong credit balance which may be higher than the
correct credit balance. This may be due to i) duplication of credit entries, ii) incorrectly high amount for credit entries,
of iii) omission of any debit entry. The legal position of banker and his customer in such a situation would be as

        i) The pass book is written by the banker and hence the entries therein may form an evidence against the
banker. The customer is rightly entitled to believe them as correct and to act on the basis of such entries. If the pass
book shows a higher balance and the customer withdraws such balance treating it as his own and subsequently
spends it away, the banker shall not be entitled to recover such amount wrongly paid to the customer. But the
customer shall have to prove that a) he acted in such manner relying on the correctness of the balance shown in the
Pass Book and had no knowledge of the mistakes therein, and b) he altered his position by spending the same. This
benefit has been given to the customer in various judgments because of the presumption that normally a person
spends what he presumes to belong to him and if the banker permits him to withdraw excess money on the above
presumption, it would be a great prejudice if he is called to pay it back.

        ii) There are some exceptions to the above mentioned principle of estoppel. If the customer regularly
maintains his account books and the bank regularly sends him the Pass Book (or statement in lieu of the Pass Book)
the customer cannot act on the basis of the above presumption. Tough it si not obligatory for him to check the Pass
Book (or the statements), but in such circumstances, it is difficualt to establish that he was igrnoratn about the
mistakes in the Pass Book, because he regularly maintained the account books. In such circumstances, a
constructive notice of the mistake is supposed to have been given to him.
        The decision of the Madras High Court in Okely Bowden and Co. Vs. The Indian Bank Ltd. (A.I.R. 1964,
Madras 202) may be cited in this connection. The brief facts of the case were as follows:

       Okley Bowden and Co. had current account with the Indian Bank Ltd. at its head office at Madras. The
company had dealings with two customers at Guntur, who used to pay into the Guntur branch of the Bank amounts
payable by them to the Company and the said branch used to send advices of the amounts so paid to the head office
which used to credit the said amounts to the current account of the Company with it.

         The Guntur branch of the bank received two deposits for the credit of the Company in 1952. Each of these
credits was advised by telegram by the Guntur branch to the head office, which credited the account in the account of
the Company accordingly. The very same tow credits were advised by the Guntur branch to the head office by
ordinary post also. The head office did not apparently realize that the two credits advised by post related to the
identical credits covered by the telegrams. The head office advised the company by mistake of four credits instead of
two. The mistake was detected by the Bank in 1954 and filed a suit against the company for the recovery of the
amounts covered by the duplicate credit entries.
         The Company in the meanwhile settled its accounts with the customers at Guntur on the basis of these
entries communicated to it by the Bank. The Company, therefore, raised the point that the bank was estopped from
claiming that the two entries were duplicate entries.

       The Trial Court and first Appellate Court held that the Company had the means of knowledge and, therefore,
every opportunity to know the real position and, therefore, it could not plead estoppel against the Bank. The Courts
were of the view that it was possible for the Company to have detected the duplicate credit from perusal of the

         On appeal, the Madras High Court held that – “Generally speaking, a bank owes a duty to its customers to
maintain proper and accurate accounts of credits and debits. If a bank makes wrong credit entries without knowing
the fact at the time the entries were made and intimates to its customer the credit entries and the customer acting
upon the intimation of credit entries, alters his position to his prejudice, the bank, therefore, will be stopped from
contending that the credit refunded to it by the customer. Such an intimation by the bank is obviously a representation
made to the customer, which the customer is at liberty, in fact entitled, to act upon. Once it is acted upon by the
customer bonafide, of course, it will then be too late for the bank to resile from the credit entries they made mistakenly
and seek to have recompense by means of adjustment in the accounts or recovery of the amounts from the customer.

         The Court observed that if the Company had even cursorily scrutinized the periodic statements received by it
from its two customer, it would have detected that two of the credit entries were in fact only duplicate entries. The
Court held that the Company was negligent in scrutinizing the accounts and that it had constructive notice of the

duplicate entries and, therefore, it could not raise the plea of estoppel against the bank. It was held that the bank
could recover the amounts in question.

        In an England case Holland V. Manchester and Liverpool District Banking Co., the customer’s pass book
showed a credit balance of £ 70, due to an error for £ 60. The customer on the faith of the pass book balance draw a
cheque for £ 65, which on presentation was dishonoured. It was held in an action by the customer for damages that
the bank was liable. But it may be noted, that the banker can rectify the position before the customer acts upon it and
of course after giving due notice to the customer. But the principle of estoppel will not act in favour of customer who
acts malafide. To succeed against a banker who had made entries, the customer must prove that he was himself
acted in good faith. Usually it is difficult for a business man to prove that he had relied on a wrong credit in his pass-
book in honest belief in its accuracy, for businessmen are presumed to know the credits their accounts receive either
paid by themselves or paid by others.

           Entries Favourable to Banker : These may arise in the following ways:

           1. Wrongly debiting the account with the cheques of other customers.
           2. Posting the credit due to this account to a wrong account.
           3. Acting without customer’s mandate. As for example, when a cheque with the forged signature of the drawer
is paid.
           The legal position in this regard in stated below.

        i) The customer is entitled to recover the amount wrongly debited to his account or omitted to be credited to
his account as soon as he happens to detect the mistake. This right of the customer does not lapse even though he
returns the pass book without raising any objection about any entry or he remains silent a after receipt of the pass
book as the customer is not bound to examine the pass book periodically and regularly.

         ii) The right of the customer to get the mistake rectified is, subject to one limitation. The customer shall not be
entitled to dispute the accuracy of any such entry if the customer has acted in such a manner that the must have been
guilty of such negligence as to cause the banker’s position detrimental affected, or he treated the account as a
definitely settled account.

         But there remains the question. What constitutes is sufficient degree of negligence and what amounts to a
settled account? The older view that the silence of the customer after receiving his pass book amounted to the
admission of the correctness of the entries there in has been modified by later decisions. The continual passing to
and fro if a pass book without comment by the customer does not operate as a settlement of the account between the
banker and the customer for each occasion on which the pass book changes hand. The contention that the customer
who does not examine his pass book and discover the error is guilty of negligence and that this negligence disentitles
him from claiming to have the wrong entries debited to his account set aside has not found favour with court.

        The pass book by itself cannot be considered as a conclusive proof of a settled account. If a banker wants a
settled account, the only course open to him is to get writing from the customer to that effect. Banks now-a-days
periodically issue to the customers balance confirmation slips, which give the balance in the account as on a given
date. By signing the balance confirmation slips, the customer accepts and confirms such balance. The legal effect of
the confirmation is to shift the bonus of proof from the banker to the customer. It does not mean that either party is
debarred from challenging the correctness of the entries but the party challenging must prove his contention.
Confirmation of the account amounts to a settled or stated account which either party will have difficulty in reopening
except on the grounds of fraud or misrepresentation.

        In Allahabad Bank Ltd. V. Kulbhushan (1961), the defendant signed the confirmation slip accepting the
balance due. Subsequently he found that certain cheques had been forged and charged to his account. He reported
the matter to the bank immediately thereafter. If was held that the confirmation slip is useless and did not preclude the
defendant challenging the action of bank in encashing of cheques.

          It is pertinent to note in this connection that the current account rules of the banks usually lay on obligation on
the banks usually examine the entries and, if any errors or omissions are discovered, to drawn them to the attention
of the bank immediately, and that the bank will not be responsible for any loss arising from neglect of this precaution.
It us, this apparent, that the current account rules, which form the basis of the agreement between the baker and the
customer, impose a duty on they customer to carefully examine the entries. If he is negligent in performing this only
duty and some loss is caused, the banker shall not be liable for the same.

                                                     LESSON – 21

                                              CROSSING OF CHEQUES

         A cheque is an unconditional order, drawn on a specified banker and is always payable on demand. The
drawer of a cheque attach any condition thereto. He may, however, give specific instruction to the paying banker
regarding the mode of payment of the cheque. Ordinarily, the payee of a cheque is entitled to encash the cheque at
the counter of the paying banker by presenting it within the specified banking hours on any working day of the bank.
In case of a bearer cheque, the paying banker need not seek the identification of the holder of the cheque. An order
cheque is paid by the paying banker on being satisfied about the true identity of the presenter of the cheque.
However, even in the latter case, there is some risk involved. The cheque might have fallen in the hands of a wrong
person, who might have taken payment from the banker. To avoid such risks, or at least to detect payments made to
wrong persons, the drawer may give a direction to the paying banker through certain words marked on the cheque
itself, which constitute ‘crossing’. Crossing is an ‘instruction’ given to the paying banker to pay the amount of the
cheque through a banker only and not directly to the person presenting it t the counter. A cheque bearing such an
instruction is called a ‘crossed cheque’, others without such crossing are ‘open cheques’ which may be encashed at
the counter of the paying banker as well. The crossing on a cheque is intended to ensure that its payment is made to
the right payee.

        Section 123 to 131 of the Negotiable Instruments Act contains provisions relating to crossing. According to
Section 131-A, these Sections are also applicable in case of drafts. Thus not only cheques but bank drafts also may
be crossed.

Type of Crossing

        Crossing on cheques is of two types-General Crossing and Special Crossing.

General Crossing
        According to Section 123, “where a cheque bears across its face an addition of the words “and company” or
any abbreviation thereof, between two parallel transverse lines, or two parallel transverse lines simply, either with or
without the words ‘not negotiable’ the addition shall be deemed a crossing, and the cheque shall be deemed to be
crossed generally”.

         It is to be noted from the above that drawing of two parallel transverse lines on the face of the cheque
constitutes ‘general crossing’. The lines must be (i) on the face of the cheque, (ii) parallel to each other, and (iii) in
cross direction (i.e. transverse). Inclusion of the words ‘and company’ is immaterial and of no special consequences.

        The effect of general crossing is that the cheque must be presented to the paying banker through any banker
and not by the payee himself at the counter. The collecting banker credits the proceeds to the account of the payee or
the holder of the cheque. The latter may thereafter withdraw the money.

Special Crossing

        According to Section 124, “Where a cheque bears across its face an addition of the name of a banker, either
with or without the words ‘not negotiable’, that addition shall be deemed a crossing and the cheque shall be deemed
to be crossed specially and to be crossed to that banker”.

         The addition of the name of a banker across the face of a cheque constitutes ‘special crossing’. Drawing of
two parallel lines on the face of the cheque is not essential in case of special crossing. Special crossing differs from
General crossing because in case of the former inclusion of the name of a banker is essential whereas in General
crossing drawing of two parallel transverse lines is a must. It should be noted that in addition to these minimum
statutory requirements for two types of crossing addition of words or lines may also he included, e.g., in case of
Special Crossing, the name of banker may be written within two parallel transverse lines or with the words and
company ‘or’ ‘Account Payee only’ or ‘Not negotiable’. The inclusion of these words has become rather customary.
         The Special Crossing on the cheque is a direction to the paying banker to honour the cheque only when it is
presented through the bank mentioned in the crossing and no other bank. The cheque crossed specially this
becomes more safe than the generally crossed cheque. The banker, to whom a cheque is crossed specially, may
appoint another banker as his agent for the collection of such cheques.

What does not Constitute Crossing?

         Sections 123 and 124 defines the two types of crossing in very clear terms. The specific lines or words which
constitute general or special crossing respectively are spelt out very categorically. The inclusion of any other
word/words, without the essential ingredients of crossing, on the face of a cheque does not constitute crossing.

        Examples: (1) A cheque bears the words ‘not negotiable’ or ‘account payee’ without two parallel lines or the
name of any bank. This is not deemed to be a crossed cheque because the words ‘not negotiable’ within two parallel
transverse lines on the face on the cheque constitute general crossing (section 123). The two transverse lines are
essential in case of general crossing. The name of a bank without two parallel lines is a must for Special Crossing.

          (2) If a cheque bears single line acrossits face or simply an X mark, the cheque is not treated as crossed

         (3) The inclusion of any other word/words within two parallel lines is irrelevant and the cheque is still deemed
to be a crossed cheque e.g.,

          Under Rupees one hundred

      & Co. Lucknow
Persons Authorised to Cross A Cheque

      Section 125 of the Negotiable Instruments Act 1881,           which corresponds with Section 77 of the Bill of
Exchange, Act 1882 enacts:

          “A cheque may be crossed generally or specially by the drawer”.

          “Where is cheque is uncrossed, the holder may cross it generally or specially”.

          “Where a cheque is crossed generally or specially, the holder may add the words not negotiable”.

       “Where a cheque is crossed specially, the baker to whom it is crossed may again cross it specially to another
banker his agent, for collection”.

         “Where an uncrossed cheque or a cheque crossed generally is sent to the banker for collection, he may
cross/it specially to himself”.

         It should be, however, noted that in the last case, such crossing does not enable the collecting banker to
avail himself of the statutory protection against being sued for conversion.

‘Not Negotiable’ Crossing

        The addition of the words “not negotiable” to a crossing is authorized by the Negotiable Instruments Act.
Section 130 of the Act provides.

        “A person taking a cheque crossed generally or specially, bearing in either case the words ‘not negotiable’,
shall not have, and shall not be capable of giving, a better title to the cheque than that which the person from whom
he took it had”.

         A cheque being a negotiable instrument, it is possible for a bona fide transferee for value to have a good title
eventhough the transferor’s title was faulty or non-existante or there was any prior defect in the chain of title. Suppose
that a bearer cheque or an order cheque duly endorsed in stolen and the thief transferred it for value to one who was
not aware of the situation. Under such circumstances, the transferee has a right to the value represented by the
cheque and the previous parties would be liable. Thus, the drawer of a stolen cheque may still find himself liable for
the amount of it even though he may have placed a ‘stop’ on it. The way to avoid such possible liability for the drawer
is to cross cheques “not negotiable”.
          If a cheque is crossed “not negotiable”, this quality of negotiability is destroyed and no one taking subsequent
to theft can acquire a good title even though the transferee gives value for it. This means that a break in the “good
title” remains broken and an innocent transferee can not acquire any better rights than those of the person from whom
he received it. No one can, therefore, be a holder in due course of such a cheque. The words “not negotiable” are a
danger signal equivalent to saying “Take care, this cheque may be stolen”. The object of the addition is to give
protection to the true owner of he cheque by preserving his rights against any subsequent holder.

        A cheque crossed “not negotiable” is still transferable. This does not mean, as is often mistakenly though, that
the cheque cannot be transferred from one person to another. The cheque is deprived of one of the attributes of
negotiability, i.e., the transferability free from equities, but is left with the other attribute unaffected, viz., the
transferability be deliver or by endorsement and delivery. A cheque crossed “not negotiable” may pass from open
person to another but the transferee should be continuous because he cannot acquire a better title than his transferor
had. This applied whether the cheque is payable to order or bearer.

        A crossed cheque “Not negotiable” does not solely, by reason of the crossing, put a collecting banker upon
enquiry, even though the cheque is tendered for collection by someone other than the payee. As Sir John Paget
observed. “the ‘non-negotiable’ crossing has nothing to do with the collecting banker and he can deal with it freely”.
Likewise, the crossing does not concern the paying banker.

Account Payee Crossing

         The expression “Account Payee” or “Account…… (name of payee, say, S. Sharma)”, are often added to the
crossing of a cheque, but such a crossing has no statutory significance as it is not sanctioned by the Negotiable
Instruments Act. In so far as the paying the cheque is good faith and without negligence, his responsibility ceases,
and he cannot be expected to follow the money after it has reached the collecting banker, and insist upon the
collecting banker paying into the proper account. But the collecting banker is in a different position.

         The crossing “Account payee” operates by customers instructions to the collecting banker that the proceeds
of the cheque are not to be collected for any account other than that of the specific payee, as otherwise he stands to
lose his statutory protection on the ground of negligence and may be liable for conversion (allowing a cheque
intended to be of benefit of one person to be converted to the benefit of another). Hence the collecting banker should
not collect cheques so marked except for the named payee.

        This crossing does present something of a legal anomaly, since be means of it the drawer of a cheque can
enforce a duty of enquiry upon a collecting bank eventhough in the majority of cases there will be no contractual link
between the drawer and the collecting bank, which will be acting for the payee or other holder of the cheque.

Double Crossing

        A cheque bearing a special crossing is to be collected through the banker specified therein. It cannot,
therefore, be crossed specially again to another banker, i.e., a cheque cannot have two special crossing, as the very
purpose of the first special crossing is frustrated by the second one.

         However, there is one exception to this rule for a specific purpose. If the banker, to whom a cheque is
specially crossed, does not have a branch at the place of the paying banker, or if he, otherwise, feels the necessity,
he may cross the cheque specially to another banker, who acts as his agent for the purpose of collection of the
cheques. In such a case, the latter crossing must specify that the banker to whom it has been specially crossed again
shall act as the agent of the first banker for the purpose of collection of the cheque, e.g.,

        Punjab National Bank
        Allahabad Bank
        as agent for collection

       It essential that the words “as agent for collection” must be included in the special crossing, subsequent to
endorsement or discharge. Section 127 provides that “where a cheque is crossed specially to more than one banker,

except when crossed to an agent for the purpose of collection, the banker on whom it is drawn shall refuse payment
thereof” Thus a cheque bearing a double special crossing as given below shall not be honoured by the paying banker.

        Punjab National Bank

        Allahabad bank

Obliterating a crossing
         Sometimes the crossing on a cheque is obliterated or erased by a dishonest person so cleverly and skillfully
that the paying banker is unable, despite utmost efforts on his part, to detect such obliteration and pays the cheque as
an open cheque. Section 89 provides protection to the paying banker under such circumstances as follows:
         “Where a cheque is presented for payment which does not at the time of presentation appear to the crossed
or to have had a crossing which has been obliterated, payment thereof by a banker liable to pay and paying the same
according to the apartment tenor thereof at the time of payment and otherwise in due course, shall discharge such
banker from all liability thereon and such payment shall not be questioned by reason of the cheque having been

        This Section provides statutory protection to the paying banker, provided the following conditions are fulfilled:

        (a) The cheque does not appear to be a crossed one at the time of presentation or the obliteration of the
crossing is not apparent, and
        (b) The payment is made according to the apparent tenor of the cheque and in due course (under Section 10)

       The paying banker is discharged from his liability if such cheque is paid at the counter on presentment. He
can debit the amount of the cheque to the drawer’s account .

Opening of Crossing

        A cheque once crossed need not remain so forever. The drawer has the right to cancel the crossing by writing
the words “pay cash” and putting his full signature. The need for full signatures was also emphasized by the London
Clearing Bankers Committee, in their resolution passed in 1912. It stated that “no opening of cheques be recognized
unless the full signatures of the drawer be appended to the alternation”. It should be noted that if holder writes the
words “pay cash” and forges the drawer’s signatures, the paying banker is not protected. The reason is that paying
banker is expected to know the drawer’s signatures and, thereof, forgery of drawer’s signatures does not entitle him
to any protection.

M.I.C.R. Cheques/Drafts

         What a view to speeding up the cheque clearing process, both local as well as intercity cheques, the Reserve
Bank of India has introduced mechanized cheque processing system using MICR (Magnetic Ink Character
Recognition) technology initially in the four metropolitan cities of Bombay, Calcutta, Madras and New Delhi. Under
this system, the cheques are processed at his speed on machines Banks issues cheques, drafts and other payment
instruments in MICR format using the special quality paper and printing securitizations. On MICR instruments, there is
code line at the bottom containing information printed in magnetic ink, which is required for mechanical processing.
The code line contains the following information.

        i) first six numbers indicate the cheque Number
        ii) next three numbers indicate the City Code
        iii) next three numbers indicate the Bank Code
        iv) next three number indicate the Branch Code

         After some space there is the number for transaction code (i.e., whether the transaction is for a savings or
current account)
         This magnetized portion, when placed under MICR equipment, allows for instant readability and identification.
         MICR cheque should not be folded. Pins, stables, etc., should only be used on the top left had corner or the
cheque. Signature of the drawer, rubber stamp, etc., should be affixed above the code line. Nothing should be written
on the code line. In place of the counterfoils, MICS cheque books provide for Record slips at the end which are used
for recording the details of every cheque issued.
                                                        LESSON – 22


         From the previous discussion it is clear that a bill can be negotiated by delivery or endorsement and deliver.
The word endorsement is derived from Latin Word, ‘indorsum’ meaning ‘at the back’ this making it clear that the
endorsement must be made on the back of the instrument with a view to transfer it to another person. Section 15 of
the Act defined endorsement as follows: “When the maker of holder of a negotiable instrument signs the same
otherwise as such maker, for the purpose of negotiation, one the back or face thereof, or on a slip of paper annexed
thereto, or so signs for the same purpose a stamped paper intended to be completed as negotiable instrument he is
said to endorse the same and is called the endorser”.

           Requisites of a valid Endorsement

         The Act lays down the following conditions that must be complied with if the endorsement is to operate as
part of the negotiation of the instrument.

         Signature: An endorsement to be valid must be signed by the holder or his duly authorized agent, and must
be written on the instrument itself. The simple signature of the payee or endorsee of an order instrument without
additional words is sufficient. Frequently additional words are added to the signature as a direction to pay the amount
in the instrument to or to the order of a specific person. The signature need not necessarily be at the foot of the
endorsement, it can be in the beginning or middle of it. An endorsement on the cheque would be signed by the
banker, otherwise than as such maker, when it is drawn in favour of ‘Self or order’. The instrument made payable to
the maker’s order needs his endorsement. No particular form of language is necessary to constitute a valid
endorsement. It is also necessary that the holder should have come into lawful possession of the instrument.

Place of Endorsement: The endorsement must be written on the back or face of the instrument itself. Endorsement is
derived from the Latin in (upon) and dersum (the back) and, as the derivation suggests, the usual place for an
endorsement is upon the back of instrument, but it is also legally permissible for an endorsement to be made on the
face of he instrument. In actual practice, in view of the time-honoured and universal practice, an endorsement is
normally written on the back of the instrument.

        Allonge: Where there are so may endorsements, already, on an instrument that there is no room for more, an
“allonge”, an additional slip of paper, may be attached to the instrument and further endorsements written on this will
be regarded on the instrument itself. An allonge is, for all intents and purposes, a part of the instrument..

        Order of Endorsement: Where there are two or more endorsements upon a negotiable instrument, it is
presumed, until the contrary is proved, that they were made in the order in which they appear thereon (Section
118(c)). A holder of a bill has his choice of remedies in case of dishonour but for the sake of notices which must be
given under Section 93 in order to hold the prior parties liable, it must be clear as to what is the order of various
endorsements. It is, therefore, of ulmost importance that each holder sings his name just below that of the person
who endorsed the bill to him.

        Copies of a bill: The English Law (Section 32 of the Bills of Exchange Act, 1882) provides that an
endorsement on a copy of a bill issued or negotiated in a county where copies are recognized is deemed to be written
on the bill itself. The Indian law does not recognize copies of which we find no reference anywhere in the Negotiable

Legal Effects on an endorsement

           The endorsement of a bill or note followed by deliver, intended to pass title to the endorsee, has four legal

           1. It transfers the property in the negotiable instrument (Section 50)

        2. It gives the right to sue the acceptor of the bill or maker of the promissory note, for recovery of the amount
due thereon.

       3. It gives the right to recover from the endorser and those above him on dishonour, provided requisite
proceedings on dishonour are duly taken.
        4. It gives the holder the right of further negotiating the bill as holder, or holder in due course, depending upon
the nature and validity of the title as well as on the type of endorsement, in terms of Section 50, as discussed

        General Rules regarding the Form of Endorsements:

         An endorsement must be regular and valid in order to be effective. The appropriateness or otherwise of a
particular form of endorsement depends upon the practice amongst the bankers. The following rules are usually
followed in this regard.

       1. Signature of the endorser: The signature on the document for the purpose of endorsement must be that of
the endorser or any other person who is duly authorized to endorse on his behalf. If a cheque a payable to two
persons, both of them should sign their names in their own handwriting. If the endorser signs in block letters, it will not
be considered a regular endorsement.

           2. Spelling: The endorser should spell his name in the same way as his name appears on the cheque or the
bill as its payee or endorsee. If his name is mis-spelt or his designation has been given incorrectly, he should sign the
instrument in the same manner as given in the instrument. Thereafter he may also put his proper signature, if he likes
to do so. For example, if the payee’s name is wrongly spelt as ‘Virendra Perkash’ instead of ‘Virendra Prakash’,
regular endorsement will be as follows :

        ‘Virendra Perkash’
        ‘Virendra Prakash’

        But it must be in the same handwriting. Merely writing the correct name will not be the regular endorsement.

          3. No addition or omission of initial of the name: An initial of name should neither be added not omitted from
the name of the payee or endorsee as given in the cheque. For example, a cheque payable to S.C. Gupta should not
be endorsed as S. Gupta or vice versa. Similarly, a cheque payable to Harish Sexena should not be endorsed as H.
Sexena because it will be doubtful for the paying banker to ascertain that H. Saxena is Harish Saxena and nobody
else. It is possible that some Hari Sexena has signed on the cheque as H. Sexena.

       4. Prefixes and Suffixes to be excluded: The prefixes and suffixes, to the names of the payee or endorsee
need not be included in the endorsement. For example, the words “Mr. Messrs. Mrs. Miss. Shri, Shrimathi, Lala,
Babu, Genernal, Dr., Major, etc. need not be given by the endorser otherwise the endorsement will not be regular.
However, an endorser may indicate his title or rank, etc., after his signature. For example, a cheque payable to Major
Raja Ram or Dr. Laxmi Chandra may be endorsed as ‘Raja Ram, Major’ or ‘Laxmi Chandra, M.D.’ A cheque payable
to Padmashri Vishnu Kant may e endorsed as Viushnu Kant, Padmshri.

Kinds of Endorsements

        According to the Negotiable Instruemnts Act, endorsements are of the following kinds:

        General or Blank Endorsement:

        An endorsement is called General or Blank where the payee or the endorsee merely signs his name on the
bank of the instrument without stating the name of the person tot whom it is payable e.g., Vijay Amritraj.

        The holder of an instrument endorsed in blank can convert that endorsement into a full one by putting his own
name or the name of any other person above the endorsement. In the example given above, R. Krishnan to whom the
cheque is given may write above the signature of Vijay Amritraj the words, pay to R. Krishnan or if he wants to pass
on the instrument to Sambudass he can write over the signature of Vijay Amritraj the words “Pay to Sambudass”. In
this case the writing operates as a full endorsement from Vijay Amritraj to Sambudass and Krishnan does not incur
any liability as endorser. The effect of this endorsement is to make the instrument payable to bearer even though it
was originally made payable to order.

        Endorsement “in full”

         If the endorser adds to his signature a direction to ay the amount mentioned in the instrument to, or to the
order of a specific person, the endorsement is said to be “in full” (Section 16(1)). Examples of endorsement “in full”
(called ‘special endorsement in the Bills of Exchange Act) are:

        i) “Pay X or Order”
        ii) “Pay to the order of X”, and
        iii) “Pay X”

         If the endorsement reads as “Pay X” followed by the signature of the endorser, then this is equivalent to “Pay
X or Order” and X can in turn endorse (Section 8(4) and 8(5) of the Bills of Exchange Act 1882). The endorsement
“Pay to the order of X” followed by the endorser’s signature is also equivalent to “Pay X or order”

         The Act provides that any holder may convert an endorsement in blank into an endorsement in full, by writing
an order to pay a specific person over the signature of the endorser, and the holder thereby does not incur the
responsibility of an endorser (Section 49). The cheque/bill will then require the endorsement of the person whose
name has been inserted in it, if it is blank V. Gupta, If W Singh, the holder of the cheque converts the endorsement ‘in
blank’ into an endorsement ‘in full’ by writing his transferee’s name (Pay to D Sharma or order) above the signature
or V Gupta, he would make the cheque payable to D Sharma without incurring himself the liability of an endorser. The
endorsee may in turn endorse in blank or in full.

         Restricitve Endorsements: The terms ‘restrictive’ means that the rights of the endorsee are restricted in some
way. There are two kinds of restrictive endorsements (Section 50). The common type of restrictive endorsement is
that which prohibits further transfer of the instruments as, for example, when the endorsement reads “Pay to X only”.
Another important type of restrictive endorsement is when it clearly indicates that it is not intended to transfer
ownership in the instrument but to merely give the transferee authority ot deal with the instrument for some limited
purpose. For example, in “Pay (e.g., a banker) or order for collection”, the order is to pay Y or some person Y might
indicate by endorsement (“or oder”) in order that Y or his endorsee may collect the proceeds of the instruments from
the person who made the endorsement. Such an endorsements is used by a bank on negotiable instruments sent to
another bank for collection. The primary purpose of such an endorsement is to prevent any wrongful dealing with the
instrument. It gives the endorsee the right to receive payment of the instruments but gives him no power to transfer
his rights as endorsee.

Conditional Endorsement

          If the endorser of a negotiable instrument, by express words in the endorsement, makes his liability, or the
right of the endorsee to receive the amount due thereon, dependent on the happening of a specified event, although
such event may never happen, such endorsement is called a conditional endorsement (Section 52)

        Such an endorser gets the following rights:

         a. He may make his liability on the instrument conditional on the happening of a particular event. He will not
be liable to the subsequent holder if the specific event hoes not take place, the endorsee in such a case can sue
other parties to the instrument even before the particular event takes place.

         b. He may make the right of the endorsee of the instrument conditional on the happening of a particular event.
For example, “Pay C is he returns from Bombay”. Thus C gets the right to receive payment only on the happening of
a particular event i.e. if he returns from Bombay. If the event does not take place, the endorsee cannot sue any of the

        Conditional endorsements do not make the instruments non-transferable. However, such endorsements are
generally not used:

        Endorsement “Sans Recourse”

        An endorser of a negotiable instruments may, by express words in the endorsement, exclude his own liability
thereon (Section 52). For example, if R endorses as cheque as follows:

        i) Pay to X or order at his own risk
        ii) Pay to C without recourse to me

         The (R) will not be liable to X or any of the subsequent endorsees if the bank dishonours the cheque
subsequently. They may sue any party prior to such endorser. But if an endorser who so excludes his liability
afterwards becomes the holder of the instrument, all intermediate endorsers are liable to him. For example, R has
excluded his personal liability by endorsing the cheques “without recourse”. He transfers it to B, B endorses to C, who
endorses it back to R. Thus R shall have the rights as endorsee against B and C, who endorsed the instrument,
before it came back to R.

        Facultative Endorsement

         The endorsee must give notice of dishonour of the instruments to the endorser, but the latter may waive this
duty of the endorsee by writing in the endorsement ‘Notice of dishonour waived’. The endoser remains liable to the
endorsee for the non-payment of the instrument.


                                                       LESSON – 23

                                       HOLDER AND HOLDER IN DUE COURSE

         A negotiable instruments is transferable from person to person. The Negotiable Instruments Act confers upon
the person, who acquires it bona fide and for value, the right to posses good title to the instrument. Such person is
called ‘holder in due course’. Each and every person in possession of a cheque or bill cannot be its holder in due
course and cannot claim the statutory protection granted under the Act. If an instrument falls into wrong hands, the
holder thereto cannot enjoy the privileges of a holder in due course.


         According to Section 8 the “holder of a promissory note, bill of exchange or cheque means any person
entitled in his own name to the possession thereof and to receive or recover the amount due thereon from the parties
thereto”. A person is called the holder of a negotiable instrument if the following condition are satisfied.

        a. He must be entitled to the possession of the instrument in his own name and under a legal title. Actual
possession of the instrument is not essential; the holder must have the legal right to possess the instrument in his
own name. It means that the title to the instrument is acquired lawfully and in a proper manner. For example, if a
person acquired a cheque or bill by theft fraud, or forged endorsement of finds it lying some where, he does not
acquire in his name legal title thereto and hence he cannot be called its holder.

        b. He must be entitled to receive or recover the amount from the parties concerned in his own name. For this
purpose it is essential that the name of the holder appears on the document as its payee or endorsee, if it is an order
instrument. In case of bearer instrument, the bearer may claim the money without having his name mentioned on the
cheque. The holder is competent to receive payment or recover the amount by filing a suit in his own name against
other parties, to negotiate the instrument and to give a valid discharge.
        In case a bill, note or cheque is lost or destroyed, its holder is the person so entitled at the time of such loss
or destruction (Section 8). In other words, the person who was entitled to receive payment at the time the instrument
was lost, will continue to be regarded as its holder; the finder does not become its holder.

Holder in Due Course

        According to Section 9, “holder in due course means any person who, for consideration, became the
possessor of a promissory note, bill of exchange or cheque, if payable to bearer, or the payee or endorsee thereof if
payable to order, before the amount mentioned in it become payable, and without having sufficient cause to believe
that defect existed in the title of the person from whom he derived his title”.

         A person becomes a holder in due course of negotiable instrument is the following conditions are satisfied:

        i) The negotiable instrument must be in the possession of the holder in due course. In case of an order
instrument, he must be its payee or endorsee, i.e., his name must appear on the instrument.

        ii) The negotiable instrument must be regular and complete in all aspects. Alterations, if any, must be
confirmed by the drawer through his signature. Holder of in incomplete document cannot be its holder in due course.
The instrument must have been properly delivered to the holder in due course. In case of an order cheque
endorsement in favour of the holder is essential.

        iii) The instrument must have been obtained for valuable consideration, i.e., by paying its full value. A person
who receives a cheque as a gift will not be called its holder in due course for want of consideration. The
consideration must be legal and adequate. For example, if a cheque is given in respect of a debt incurred in
gambling, the consideration for the cheque is unlawful. If the value of the consideration falls short of he amount of the
instrument, the person will be deemed as holder in due course to the extent of the value of consideration.
        iv) The instrument must have been obtained before the amount mentioned therein becomes payable. This
condition is applicable to documents payable otherwise than on demand and does not apply to a cheque which is
always payable on demand.

        v) The holder in due course must obtain the instrument without having sufficient cause to believe that any
defect existed in the title of the transfer. This is the most important condition to be satisfied. The title of a person to the
negotiable instrument is deemed to be defective if he acquires it by unfair means, e.g., by fraud, coercion, undue
influence or by any other illegal method or for an illegal consideration. If he does not possess any title thereto, his title
is also deemed to be defective.

         Section 9 lays heavy responsibility on the person accepting a negotiable instrument in this regard. He should
not only have no notice of any defect in the transfero’ stitle thereto, but he should have no cause to believe that the
title was defective. In means that the circumstances of the case should not give rise to any doubt or suspicion about
the defective title or the transferor. The holder in due course should, therefore, exercise great care and take all
necessary precautions in finding out if the transferor’s title was defective. If he shows negligence or does not take due
care in this regard, he shall not be called the holder in due course.

       Difference between Holder and Holder in Due Course: Form the definitions of the terms ‘holder’ and ‘holder in
due course’ we may derive the following points of difference between them:

1. Consideration: The existence of consideration is not essential in case of a holder, but a holder in due course
obtains the instrument after paying its full value. For example, if a cheque is used to provide a gift or donation to a
Charitable Trust, the Trust does not become its holder in due course. On the other hand, tuition fee paid to a school
or college is for a valuable consideration. Hence the school or the college acquire the status of holder in due course.

2. Possession: The person entitled to be called holder in due course must become the possessor of the instrument
before it became payable. For example, if a bill of exchange is payable on March 20, 1984, a person who possesses
it before this date is entitled to be its holder inc due course. If it is obtained after this date, the possessor will not be
called its holder in due course. In case of a holder neither actual possession nor any time limit within which it must be
acquired is required.

3. Defect in the transferor’s title: The most important point of difference is that a holder in due course acquires an
instrument without having sufficient cause to believe that any defect existed in the title of the transferor. This condition
is not essential in case of a holder. This condition casts a heavy responsibility on a person who claims to be a holder
in due course-he should not only have the knowledge of the defective title of the transferor but in the circumstances of
each case, there should be no cause to believe that any defect exists in the title of the transferor. It means that the
holder in due course must obtain an instrument after taking all possible care about the transferor’s good title.

Right of a Holder

        The holder of a negotiable instrument enjoys the following rights:

        i) An endorsement in blank may be converted by him into an endorsements in full.

        ii) He is entitled to cross a cheque either generally or specially and also with the words “Not Negotiable”.

        iii) He can negotiate a cheque to a third person, if such negotiation is not prohibited by the direction given in
the cheque.

        iv) He can claim payment of the instrument and can sue in his own name on the instrument.

        v) A duplicate copy of a lost cheque may be obtained by a holder.

The Rights and Privileges of the Holder in due course

          1. A holder in due course gets a perfectly good title to the instrument. He is not affected by any defects in the
title of the transferor or the previous parties. Just as in the case of a devout Hindu and dip in the Ganges frees him
from all the sins, a negotiable instrument in the hands of a holder in due course is relived of all is previous defects.
What is more important is that all the holders subsequent to him are also protected. They obtained the same rights
and privileges as that of the holder in due course.

        The implication of this right is that the acceptor of the instruments or maker of a note cannot plead against the
holder in due course any right of set-off or a counter claim which he might have had against the transferor of the

        2. He can recover the amount from al the previous parties. All of them will continue to be liable until the
instrument is duly satisfied.

        3. Sometimes instruments might have been delivered conditionally or for a special purpose. When such an
instrument comes into the hands of a holder in due course, the other parties cannot escape liability on the ground that
the condition or special purpose not be fulfilled.

        4. In the case of inchoate instruments, he can recover the full amount covered by the stamp.

       5. His title is not affected even if the instrument was the result of fraud or any other offence as between
immediate parties. Holder in due course cannot, by very definition, be one of such parties.

        There are, however, some exceptions. The signature on the instrument must not be the result of forgery. The
instrument must not be vitiated due to lack of consent (absence of consensus ad idem) right from the beginning. In
these cases, the holder in due course is affected by the defects of the instrument like any other holder.

        6. Every holder is presumed to be a holder in due course unless proved otherwise.

        7. The person liable to pay cannot set up defences against the holder in due course that the instrument has
been lost or obtained from him by means of a fraud or unlawful consideration.

        8. Acceptor is precluded from denying against the holder the existence of the drawer, genuineness of his
signature, his capacity to draw, or to endorse or existence of the payee and his capacity to endorse.

        9. The drawer is precluded from denying the existence of payee and his capacity to endorse.

       10. So also the endorser is estopped form denying the genuineness of drawer’s signature or of the
genuineness of previous endorsements.

        11. Acceptor cannot raise the plea against the holder in due course that the drawer is a fictitious person.

Payment in due course

         The payment of a negotiable instruments should be made to the right person by the paying banker or the
acceptor of the bill, otherwise the latter shall be responsible for the same. The Negotiable Instruments Act, provides
protection to the paying banker or the drawee of a bill, provided the payment is made as required in the Act. Such
payment is called ‘payment in due course’.

        Section 10 states “payment in due course means payment in accordance with the apartment tenor of the
instrument in good faith and without negligence to any person in possession thereof under circumstances which do
not afford a reasonable ground for believing that he is not entitled to receive payment of the amount therein

        Analysis of Section 10 reveals that the following conditions must be satisfied before a payment of a
negotiable instrument can be called as a payment in due course:

1. Payment must be in accordance with the apparent tenor of he instrument: It is necessary that a payment to
constitute a payment in due course should be made at or after maturity. A payment before maturity is not payment in
due course. For example, payment of a post-date cheque is not a payment in due course.

2. The payment must be made in good with faith and without negligence: When there exist suspicious
circumstances and the paying banker fails to make any enquiry as to them, the payment is not in due course. So
payment is not in due course where a banker makes payment on a cheque materially altered with out exercising due

3. Payment must be made to the person in possession of the instruments: A payment is not a payment in due
course if it is made to a person not entitled to receive it. A thief is not said to be in possession of the instrument. Thus,
in the event of suspicious circumstances, payment should not be made without drawer’s confirmation.

4. Payment must be made under circumstances which do not afford a reasonable ground for believing that the
holder is not entitled to receive payment of the amount mentioned therein. So, where a peon of a company presents a
cheque for a big amount of behalf of the company, which is contrary to the past experience, the banker should
conduct proper enquiry before making payment on such a cheque.

5. Payment must be made in money only: Payment must be made in money only unless the payee to accept
payment in some other form (e.g., bill of exchange or promissory note). Money includes bank notes or currency notes
but excludes cheque, bill of exchange, promissory note and goods.


                                                      LESSON – 24

                                                  PAYING BANEKER

          The bank undertakes to receive money and to collect bills for its customer’s account. The proceeds so
received are not to be held in trust for the customer but the bank borrows the proceeds and undertakes to repay
them. The promise to repay is to repay at the branch of the bank where the account is kept and during banking hours.
It includes a promise to repay any part of the amount due, against the written order of the customer addressed to the
bank at the branch, and, as such written orders may be outstanding in the ordinary course of business for two or three
days, it is a term or the contract that the bank will not cease to do business for two or three days, it is a term of the
contract that the bank will not cease to do business with the customer except upon reasonable notice. The customer,
on his part, undertakes to exercise reasonable care in executing his written orders, so as to mislead the bank or to
facilitate forgery.

         “I think it is necessarily a term of such contract that the bank is not liable to pay the customer the full amount
of his balance until the demands payment from the bank at the branch at which the current account is kept. Whether,
he must demand it in writing it is not necessary now to determine,” (Joachimson V. Swiss Banking Corporation).

           This passage clearly portrays the duties of the paying banker and his obligation to honour customers’ cheque.
The banker’s primary duty is to repay moneys received for his customer’s account, usually by honouring his cheques.
It is this function that constituted the hallmark of a banker that delineates him from other institutions receiving money.
This obligation to pay cheques has been specifically laid down in Section 31 of the Negotiable Instruments Act and
has already been discussed under “Obligation to honour Customer’s mandate.”

Precautions to be taken by the Paying Banker

        The paying banker should ensure that the cheque is regular in all aspects and should take the following
precautions while making payment of his customer’s cheques.
1. Proper Form of the Cheque

        The Negotiable Instruments Act defines a cheque but does not prescribe its form. Nor does it require that a
cheque should be drawn on the printed form issued by the bank. The banker should, therefore, not dishonour a
cheque drawn on a piece of paper provided it carries an unconditional order to the banker and fulfils other requisites
of a cheque. But almost every bank in India requires that ‘cheques must be drawn on the bank’s printed forms’ and
‘the bank reserves its right to refuse payment of any cheques drawn otherwise’. This makes it essential that the
cheque forms issued by the banker must be used by the customers.

        Advantages of using Printed Forms: Drawing of cheques on the printed forms issued by a banker is
desirable because of the following advantages:

       i) It is convenient for the drawer to draw a cheque. He need not take necessary precautions while drafting a
cheque as per the requirements of the Act. The chances of dishonor of the cheque are thus minimized.

        ii) The counterfoils of the cheques serve the purpose of record for future reference.

       iii) If the drawer wishes to countermand payment of any cheque, he can issue instruction to the banker more
conveniently and with certainty as every cheque form is serially numbered and can be easily identified.

        iv) If the customer keeps the cheque book safely and carefully, chances of forgery can be minimized. The
serial numbers of the cheque forms issued to a customer are recorded by the banker, who verifies, at the time of
presentation, that the cheque is drawn by a person to whom the relevant cheque book is issued.

2. Date of the Cheque

         A cheque must bear a date because the mandate of the customer to the banker given in the cheque becomes
legally effective on the date mentioned therein. The drawer of a cheque fills in the date before the cheque is issued,
but if he has not done so, the instruments does not become invalid. The payee of the cheque or any subsequent
holder thereto may fill in the date. But if an undated cheque is presented for payment, the banker must refuse its

       The date should not be incomplete, i.e., it must include besides the year, the name of the month and the
number of the day. For example, a cheque bearing “February 1980” or “November 25, 19..” is not a complete dated
cheque as the banker must refuse its payment. If a cheques is dated “April 30, 1988”, it should be paid if it is
presented on April 30 or thereafter.

Stale Cheque:

       Under Section 73 read with Section 84 of the Negotiable Instruments Act, a cheque is required o be
presented for payment within a reasonable time after its issue otherwise the drawer will be discharged from liability
thereon to the extent of the loss caused by the delay. Though it has not been legally defined what constitutes a
reasonable time but the practice of bankers in returning cheques presented for payment six months after their
issuance has acquired the force of law.

        A cheque which is six months old is considered ‘stale’ and returned with the objection ‘out of date’. A stale
cheque requires drawer’s confirmation, though in law, a cheque is not affected by limitation for a period of three
years from the date of issue.

        A “stale” cheque may be distinguished from an ante-dated cheque. Ante-dating means putting a date on a
cheque prior to that on which it is signed intentionally or though oversight. A cheque may be treated as stale if by
ante-dating it or otherwise by remaining in circulation, it becomes older than six months. Ante-dating cheques through
oversight happens in the earlier part of new year when the old year is written in error which requires careful attention
of the bankers and the customers.

Post-dated Cheque:

        A cheque bearing a date later than on which the holder presents it for payment at the bank is a post-dated
cheque. Such a cheque should be returned by the banker with the answer “Cheque is post-dated”. A banker is,
however, bound to pay a “post-dated” cheque presented on or after its ostensible date even though he may have
refused payments of the same cheque earlier and marked it “post-dated”, when presented before the date.

        A post-dated cheque is not legally invalid. It is not a cheque payable on demand and it is equivalent to a bill of
exchange payable at a future date and thus used as a device to evade stamp duty. Post-dated cheques are generally
given by the drawers to the arties in the following circumstances:

        i) a drawer unable to meet the pressing demands of his creditors for want of funds but expecting sufficient
funds by a certain future date;

        ii) a drawer ordering goods under manufacture but disinclined to entrust cash payment to the manufacturer till
delivery of goods and getting the opportunity to stop payment of the post-dated cheque in case of non-delivery of
goods, and

        iii) borrowers raising loans on promotes and giving assurance to their creditors for timely payment by issuing
post-dated cheques.

         Negotiability of a cheque is not impaired because of its being post-dated. For example, A gives B a post-
dated cheque and B gives it to C, before the due date, in payment of a debt. C takes the cheque without notice of nay
dispute between A and B. A stops the payment because B has not fulfilled his contract. Despite this, C acquires a
good title to the cheque, and when the date is reached, he can sue A for the amount of the cheque.

         A cheque dated on Sunday should not be paid until the following working by and if presented on Saturday
previous, it should be returned marked “Post-dated”.
         Sometimes, a cheque bearing a date prior to the issue of cheque book by the banker to the customer, but
otherwise in order, is presented for payment. Supose a cheque book is issued to a customer on 20 May and he
issues a cheque from this cheque bool and dates it 10 May. Thus, the ante-dating of the cheque is established from
the facts available on bank record. In such cases, the banker may contract the drawer to get his confirmation. But if
contract with the drawer is not possible, the banker would be within his right to pay the cheque, as the cheque is in
order and there is no provision in law which prohibits ante-dating of cheque.

       Where a banker pays a cheque before the proper date of its payment, he makes the payment on his own
responsibility and cannot charge the amount to he drawer of the cheque as he has disobeyed the customer’s
mandate and authority. Premature payment of a post-dated cheque exposes the bank to danger of loss as stated

         Firstly, there is nothing to prevent the customer from stopping payment of the cheque at nay time before the
date it bears, and if he does so, the banker stands to lose the money.

       Secondly, if a banker pays a post-dated cheque and dishonours other cheques, which would otherwise have
been paid, he will be liable to his customer for damage to his credit.

        Thirdly, a banker paying a post-dated cheque would not be entitled to statutory protection on the ground that
such a payment cannot be regarded as a payment in due course.

       Finally, if the drawer dies or becomes insane or insolvent, before the date of the cheque, the drawee bank
would not be justified in debiting the amount of the cheque to the deceased/insane/insolvent drawer’s account.

3. Amount of the Cheque

        The amount of the cheque must be certain and expressed both in words and figures. In case of any
discrepancy between the amount expressed in words and figures, Section 18 provides that the amount in words shall
be the amount undertaken or ordered to be paid. The banker may, therefore, pay the practice the bankers send banks
the cheques to the drawer with the remark’ amount in words and figures differ’ and seek necessary correction by the
drawer. The Indian Banks Association has advised its member-banks not to dishonour cheques on this ground and
should pay the amount written in words in conformity with Sections 18. If the amount is expressed in words only, the
banker must pay the cheque but if the amount is written in figures only, it should be sent back to the drawer for
necessary entry.

          Funds in the account must be sufficient: The baker is under an obligation to pay his customer’s cheques if the
latter’s account shows sufficient credit balance. But if the funds in the customer’s account are insufficient to pay the
cheque, the banker is not bound to honour the cheque or even to pay the balance in the account to the presenter of
the cheque. Cheques are to be paid in full and not in part. For example if a cheque for Rs. 1,000 is presented for
payment to a banker while the drawer’s account has the credit balance of Rs. 900 only, the banker is not bound to
honour the cheque or to make art payment to the extent or Rs. 900 because the cheque contains the order of the
drawer to pay a specified sum of money. While considering sufficient funds in the account of the drawer, the following
points should be borne in mind by the banker.

        i) If the banker has already agree to grant a loan or overdraft to the customer up to a certain amount, cheques
in excess of the credit balance in the account but within the limit of the loan of the overdraft must be honourded byt eh
banker in the usual course. For example, if the banker agrees to grant Mr. X an overdraft up to Rs. 5,000 he should
honour cheques issued by Mr. X till the debit balance reaches the limit of Rs. 5,000. If subsequently, the banker
decides to reduce the overdraft limit to say Rs. 2,000 only, he should not stop honouring the customer’s cheques
immediately. For this purpose he should give due notice to the customer and cheques in excess of the debit balance
of the Rs. 2,000 be dishonoured after the service of such notice.

        ii) The minimum balance required to be maintained in a current account of savings accounts is deemed as
available for honouring the cheques. That amount should not be regarded as frozen by the banker. If the minimum
balance is reduced below the prescribed amount, the banker should honour the cheque and may charge an incidental
charge from the customer for this default.

         Payment be made in chronological order of receipt. In case of a current account, any number of cheques may
be presented for payment on a single day. The banker generally follows the rule of making payments of the cheques
in the chronological order of their receipt. It means that the cheque first received by the banker on an account will be
paid first, and so on. The serial number of the cheque or the date of its issue is nto significant for this purpose.

         The banker may sometimes face a situation when a number of cheques are presented simultaneously for
payment or are received by one main or through the same clearing but the funds available in the account of the
drawer are insufficient to pay all of them. For example, two cheques for Rs. 500 and Rs. 300 are received by a banker
for payment while the drawer’s account shows a credit balance of Rs. 600 only. There may be two viewpoints in such
a situation.

         The banker may treat both the cheques as constituting one demand and hence dishonour both of them for
shortage of funds. But this would not be fair towards the drawer’s interest because the dishonour of both the cheques
will affect his reputation greatly while funds are sufficient to honour at least one of them. The banker will do well if he
honour as may cheques as possible till the credit balance is not exhausted. In practice, a cheque for a bigger amount
is paid first in such a situation but if a cheque for smaller amount is payable to the tax authorities etc, it may be
honoured first. If both the cheques are of equal amounts, the banker is free to honour any of them.

1. Material Alterations

        A cheque contains a mandate of the drawer to his banker to pay a specified sum of money to the bearer or
the person mentioned therein or to his order. Any alternation or correction therein, to be valid, must be made by, or
with the consent or, the drawer and confirmed by his full signature. The paying banker should be very careful in this
regard and should not make payment if the cheque bears an alternation, specially a material alteration, without
confirmation by the drawer.

A material alternation is one

        i) Which substantially changes the rights and liabilities of the parties or any of the parties to the instrument, or

        ii) Which changes the instrument, or

        iii) causes it to speak a different language from that it originally spoke or

        iv) Changes the business effect of the instrument changing the following items.

Following are the material alternations:

         a) Changing the date, b) Time of payment, c) Amount of he instrument, d) Place of payment, e) Rate of
interest. f) The number of parties by addition or deletion g) The medium of payment, h) Removal of crossing, i)
Converting order instrument into bearer etc.

Effect of alternation: It only affects the parties at the time of alternation and not affect-parties subsequent to such
alternation. A material alternation discharges the previous parties but not the subsequent ones. Under Section 88 of
the Act an acceptor or endorser is bound by his acceptance or endorsement not with standing any previous material
alternation. An alternation is material only if it is effected by the will of the person by whom or under whose direction it
is made. Therefore, an alternation which is the result of an accident does not render the instrument void. Examples of
such accidents are ravages of white ants, washing and ironing or a garments in which the document was kept;
document torn by a child etc.

        Alternation permitted by Law. The following alternations are permitted by Law:-

        1. An alternation made with the consent of all parties.

        2. Alternation made in order to carry out the common intention of the original parties.

        3. Conversion of an endorsement in blank into an endorsement in full.

        4. Completing an inchoate instrument.

        5. Crossing of an open cheque, conversion of general crossing to special crossing, addition or words like not
negotiable to a crossed cheque.

        Material alternation in the case of cheques: Bankers refuse to pay cheque materially altered unless every
such alternation is properly attested by the full signature of the drawer which should tally with the specimen held by
the banker. Where the cheque is drawn by joint account holder all of them attest such alternations.

         If a banker pays a cheque which has been altered without the customer’s consent, then the bank has no right
to debit the customer’s account. It no longer represents the customer’s mandate. Therefore the banker has to bear
the loss himself unless he is in a position to recover the money from the person responsible for such alternation.
However the banker can debit can debit the customer’s account with the amount of such a cheque.
        1. where the customer did not exercise proper care in drawing the instrument and

        2. the alternation was not apartment. (London Joint Bank Ltd., V Macmillan and Arthur)

        Statutory protection to the Paying Banker when a cheque is materially altered.

        Section 89 of the Negotiable Instruments Act give protection to a paying banker who pays a cheque which is
materially altered provided the following conditions are satisfied.

        1. Such alternation is not apparent:

        2. Banker has made the payment in due course, and

        3. Banker is liable to pay the cheque.

       The paying banker may, therefore, avail of the statutory protection under Section 89, in case of cheques
which have been materially altered provided.

         a. The alternation is not apparently clear i.e., it cannot be detected with reasonable care, prudence and
scrutiny. For example, if the drawer has written the amount so carelessly by leaving sufficient space before the
amount (both in words and figures) and the holder or any other person raises the amount so carefully that the
additions of the words and figures cannot be detected with due care and scrutiny on the part of the banker, the latter
shall not be held responsible for paying the amount so altered. The customer, in fact, would be guilty of breach of his
duty towards the banker to take due care in drawing the cheque. The banker need not undertake any specific
investigation in this regard. What the law requires him to do is that he should ensure that the alternation is not
apparent to the naked eye. If, for example, the additions of a word is in different handwriting or with a different ink, the
alternation appears to have been made. But if the amount has been altered with the same ink and in the same
handwriting even by the cleark of the drawer, after getting the cheques signed, the banker would be justified in
honouring the cheque.

          b. The payment has been made in due course as defined in section 10. the paying banker is discharged from
his liability on the cheque and he can debit the account of the drawer with the amount of the cheque.

When is the alteration apparent?

It was observed in woolatt V. Salter.J (1928) “ An alteration in a bill is apparent within. Section 64, if it is of such a kind
that it would be observed and noticed by an intending holder scrutinizing the document, which he complete taking
with reasonable care”

Case Low

        1) In Tanjore permanent bank Ltd. V.S.R Rangachari, the defendant gave two cheque singed in blank and
handed over to the official of bank. The official filled the cheques by making them payable to the customer’s clerk.
Subsequently he forged their endorsements and misappropriated the money. The banker in the appeal was denied
the statutory protection because of the fact the alternations were material and apparent and were not authenticated
by the drawer. Protection was also denied on the ground that there was no evidence of the payment to the ostensible

         2. In Brahma Shum Share Jug Bahadur V. Chartered Bank of India, Australia and Chine (1956) the paying
banker obtained the statutory protection under Section 89 of the Act because the alternation was not apparent. The
facts of the case were, a cheque for Rs.256 drawn in favour of J.M. Das Gupts was stolen in transit and materially

         The instrument was materially altered by raising the amount to Rs. 2,34,801 and changing the name of payee
to S Dass and Co. The learned Judge held that the instrument on its face did not disclose any trace of alternation or
obliteration and therefore the drawee bank is entitled to Statutory Protection.

5. Forgery of Drawer’s signature

        The paying banker should carefully ascertain that the cheque bears the genuine signature of the drawer after
comparing the same with his specimen signature. The cheque must be signed by the drawer on its face and not on its
back. The account holder may change his specimen signature any time and supply to the banker his fresh specimen
signature. Banker is bound to accept the new specimen signature with effect from a specified date.

        Thus a bnaker has to ensure that the drawer’s signature on the cheque are authorized and genuine. The
signature of the drawer or his authorized agent on the cheque must confirm to the one already held by the bank, the
cheque being a mandate from the drawer to the banker. In the case of joint account the mandate on the number of
person to sign or who is to sign must be observed. The same would apply to a partnership firm’s cheque and a
corporate customer’s cheque. A cheque may be signed in a trade or assumed name, and the signature of a
partnership firm is equivalent to the signature of all the partners. Apparently, a signature by marks or a thumb
impression in the presence of the banker will suffice. The banker should exercise great care and caution in paying
cheques bearing such marks or impressions. If the drawer’s signature or the signature authorized by him differs from
the specimen signature provided to the banker, the banker should, to protect himself, either get it confirmed or return
the cheque marking it “Signature Differs”.

         Facsimile Signature (used here to denote any signature not made directly by hand, and include signature
made by stamp, print or any signature writing machine) frequently appear on dividend and interest warrants. A
facsimile signature is valid and binding if impressed by authority. A bank would authorize the use of a facsimile
signature on cheques only if the account holder gives a suitable indemnity against the risk of any loss that might
result from the unauthorized use of the signing device or by the use of an imitation which resembles the account
holder’s facsimile signature.

         Signature in an abnormal form may be required to be proved with utmost strictness in legal proceedings. If in
doubt, reference should be made to the specimen of drawer’s signature. If need be, cheques shoud be examined with
the help of special lamps. A person’s signature is likely to change over a period of time and as such a banker should
obtain fresh specimen signature of customers periodically.

         It is the responsibility of the paying banker to carefully ascertain that the drawer’s signature on the cheque is
genuine and authorized when written by an agent and is the same as per specimen signature supplied to him. When
a cheque baring the forged signature of the drawer is paid by the crewee bank, the loss generally falls upon the bank
unless the forger can be apprehened and the money recovered from him. A forged signature is ‘wholly inorperative’
and the bank, therefore, has no authority to debit the account when the customer’s signature is forged. However, the
only circumstance which would impose loss upon the account-holder, rather than the drawee bank, would be the
existence of the facts precluding the account-holder from denying the genuineness of the signature.

Exceptional Circumstances

        There may be exceptional circumstances which will enable the banker to debit his customer’s account
bearing a forged signature. The customer by his conduct may have misled the banker, causing him to pay the cheque
when otherwise it might have been refused. The banks are protected by estoppels or personal bar when they make
payments on cheques to which their customer’s signature as drawer has been forged. For example:

        i) If the customer does not repudiate the signature as soon as the forgery comes to his notice and the banker
pays it when otherwise he would have returned it or if the banker is thereby prejudiced in any action that he might
take against the forger, or

       ii) If by some net of his or by his conduct, the customer has induced the bank or to believe that the signature
was a genuine one.

         A party is “precluded” when he is “stopped” form raising the question of the forgery or want of authority. What
particular act or line fo conduct which precludes the drawer from denying the banker’s right to debit him with a forged
cheque is a question of fact. Silence may result in a party being precluded from alleging forgery or want of authority,
when he knows of the irregularity, is under a duty to reveal it to the other party and the other party is prejudiced by the
silence. The position will be clear form the judgment given in the decided cases cited below:

        In Greenwood V. Martin Bank Ltd. (1933), a customer of the bank learnt that his wife has forged cheques on
his account. In breach of his duty as customer, he did not tell the bank of these forgeries until after his wife died. He
then claimed that the bank should repay to his account the sum which had been paid away on the wife’s forgeries, on
the basis of the general rule that a banker is not entitled to debit a customer’s account when the customer’s signature
as drawer has been forged on a cheque. It was held by the House of Lords that the husband was precluded from
making such a claim in respect of all the cheques by his own failure to notify the bank of the original forgeries.

         This has induced the bank to believe that they were genuine cheques signed by husband himself, and so had
prevented the bank from pursuing the remedy it would have of suing the wife for fraud. Moreover, the bank has been
led to honour further forged cheques by the husband’s inaction.

        The validity of the principle of preclusion was reiterated in a later case.

         In Brown V. Westminister Bank Ltd. (1964), where the customer, a widow aged 86, whose affairs were largely
looked after by a man she employed, claimed that the bank should restore to her account money padi out on some
300 cheques for small amounts which the employee had forged for over two years. During tht period she had been
visited by her bank mananger with statement of her account at six-month interval and she had not responded to his
request on each occasion that she should check the statement of account and let him know whether they were in
order, but had either affirmed that they were satisfactory or had said nothing. It was held that the customer must have
realized that the cheques had been forged with her signature from their sheer number, and therefore she had failed in
her duty to inform the bank of this and could not now claim that the debit entries should be cancelled.

6. A Cheque should not Mutilated
        If a cheque is torn by the drawer with the intention of canceling it, as may be evident from the condition of the
cheque, the banker will have to suffer loss, if any, arising from paying the cheque to a person who presented it after
pasting the pieces together. If a cheque is torn accidentally by the payee, mutilation must be confirmed by the drawer
or guaranteed by the collecting banker before it is paid by the drawee-banker. In the absence of such a
confirmation/guarantee, the banker on whom the cheque is drawn should return it with the answer “Cheque
mutilated” or “Mutilation required drawer’s confirmation”. Occasionally, cheques are torn at the office of the collecting
bank while opening inward mail, etc. If the collecting bank confirms mutilation, the paying should pay the cheque. If a
cheque is slightly torn without affecting the drawer’s or other material particulars, its payment may not be effused.

A Cheque must be presented within Banking Hours

         As provided in Section 65 of the Act, a cheque must be presented for payment within banking hours. But
actual banking hours are fixed by custom and not by statue, and reasonable notice of such change must be given
both in the press and by a notice prominently displayed in full view of the public inside the bank.

         There is a dual danger in paying cheque other then to the drawer, when presented out of banking hours.
First, by paying a stolen cheque bearing a forged endorsement the paying banker would be liable to the true owner
and to the drawer as he may lose statutory protection of Section 85 for the reason that a payment out of established
banking hours would not be payment in due course. Secondly, a customer might countermand payment of the cheque
in question and bring evidence to show that it had been physically impossible for the cheque to be presented within
banking hours on the same day he drew it. In such a case the customer might successfully resist being charged with
the amount in question.

Statutory Protection to the Paying Banker

         Payment of cheques involves risk to the paying banker because the latter’s duty is to pay the amount of the
cheque to the right person according to the instructions of his customer. If he makes payment to a wrong person, he
himself will bear the loss. The banker has to honour his customer’s cheques on demand and hence he cannot make
detailed enquires about the title of the person who presents the cheque for payment. To minimize losses likely to be
suffered by the paying banker, the Negotiable Instruments Act provides him protection, provided he fulfils his
obligations as laid down in the Act.

Protection in case or Order Cheques

        In case of an order cheque, Section 85(1) provides statutory protection to the paying banker as follows:

        “Where a cheque payable to order purpose to be endorsed by or on behalf of the payee, the drawee is
discharged by payment in due course.

           This Section grants protection to the paying banker if he makes payment of an order cheque with forged
endorsement on behalf on the payee. After the insertion of Section 16(2), this protection is available in respect of
other endorsements also, because the banker is not expected to verify the signature of each and every endorser. The
main object of this section is “to make the banker free of al responsibilities in respect of the genuineness, or the
validity of the endorsement purporting to be that of the payee or his authorized agent”. Two conditions must be
fulfilled to avail of such protection.

         a. Endorsemnt must be regular: Section 85(1) provides protection against the risk involved in the payment of
cheques, which bear endorsements. But it is essential that the endorsements are regular though not necessarily
genuine or valid. There is a difference between the regularity of endorsement and its validity or genuinesses. If a
cheque payable to a certain person is endorsed under the signature bearing the same name and in the same spelling
as that of the payee or the endorsee, the endorsement is said to be regular.

         Apparently, it appears that the cheque has been endorsed by the person whose name appears as the payee
or the last endorsee. A valid endorsement is that endorsement which has been made by the person who is the true
owner of the cheque or has the necessary authority to sign on behalf of the payee. To avail of the statutory protection,
the banker must ascertain that the endorsement is regular. He need not verfity its validity. For example, if a cheque
payable to “Suresh Chandra” is endorsed with the signature of the same name and in the same spelling, it is a regular
endorsement. But if the endorser signs as “Suresh Chandra”, the endorsement will be irregular. The banker need not
concern himself with the identification of the person who signs on the cheque as the endorser. If a cheque is payable
to A and B jointly, it must be endorsed by both of them in their own handwriting. Otherwise, it will be an irregular

b. Payment must be made in due course: As already noted, Section 10, defines a payment in due course as
payment in accordance with the apparent tenor of the instrument in good faith and without negligence to any person
in possession thereof under circumstances which do not afford a reasonable ground for believing that he is not
entitled to receive payment of the amount mentioned therein. It is, therefore, essential that the banker pays the
cheque in good faith and without negligence, otherwise statutory protection cannot be granted to the paying banker.

Protection in case of Bearer Cheques

        Section 85(2) provides protection to the paying banker in respect of bearer cheques as follows:

        “Where a cheque is originally expressed to be payable to bearer, the drawee is discharged by payment in due
course to the bearer thereof, not withstanding any endorsement whether in full or in blank appearing thereon, and
notwithstanding that any such endorsement purports to restrict or exclude further negotiation.

This section that cheque originally issued as bearer cheques always retains its bearer charcter irrespective of the fact
that it bears endorsement in full or if bland or whether any endorsement restricts further negotiation or not. Thus the
banker is not required to verify the regularity of the endorsements on bearer cheques, even in case of endorsement in
full. The banker shall be discharged if the makes payment of an uncrossed bearer cheque to the bearer in due
course. If such a cheque is stolen and the banker makes its payment without the knowledge of such theft, he will be
discharged of his obligation and will be protected under Sections 85(2).

Protection in Case of Crossed Cheques

         The paying banker is under an obligation to make payment of the crossed cheques in accordance with the
instruction of the drawer conveyed through the crossing. If the does so, he is protected by Section 128 which lays

         “Where the banker on whom a crossed cheque is drawn has paid the same in due course, the banker paying
the cheque, and (in case such cheque has come to the hands of the payee) the drawer thereof shall respectively be
entitled to the same rights, and be placed in the same position in all respects, as they would respectively be entitled o
and placed in if the amount of the cheque had been paid to and received by the true owner thereof”.

       The banker making payment of a crossed cheque is, thus, given protection under Section 128 if we makes
the payment after fulfilling the following two requirements.

        a. He was made payment in due course (under Section 10), i.e., in good faith and without negligence and
according to the apartment tenor of the cheque, and
        b. The payment has been made in accordance with the requirement of he requirement of the crossing (under
Section 126) i.e., through any banker in case of general crossing and through the specified banker in case special

         Thus the paying banker is discharged from his obligation on a crossed cheque irrespective of he fact that the
payment was received by the collecting banker on behalf of a person other than its true owner. For example, if a
cheque in favour of X is stolen by Y, who endorses it is his own favour by forging the signature of X and deposits it in
his bank for collection, the paying banker shall be discharged if he makes payment as mentioned above and shall not
be liable to pay the same to X, the true owner of the cheque.

        The drawer of the cheque is also discharged as protection is granted to him also under this Section. There is,
however, one limitation to the protection granted under this Section. If the banker cannot avail of the protection
granted by other Sections of the Act., Protection under Section 128 shall not be available to him. For example, if the
paying banker makes payment of a crossed cheque with-

        i) irregular endorsement, or
        ii) a material alternation, or
        iii) forged signature of the drawer

          he loses statutory protection granted to him under the Act for these lapses on his part and hence he cannot
avail of the statutory protection under Section 128, even if he pays the cheque in accordance with the crossing.

        When a Banker is Justified in Refusing Payment:

         A banker’s obligation to honour his customer’s cheques is terminated on the happening of nay one of the
following events:

1. Notice form the customer to stop payment;

        When the customer has the right by contract to give mandate to the banker he also has the inherent right to
countermand his mandate. This is known as counter mandate of payment or stopping of the cheque. The banker
should note the following points in this regard.

         1. The order not to pay from the customer must be in writing and in clear and unambiguous terms. Otherwise
it may create confusion resulting in the payment of a stopped cheque and the dishonour of other cheques because of
insufficient balance. In Westminster Bank Ltd. V. Hilton (1926) the drawer sued the bank for having paid contrary to
instruction and for having wrongfully dishonoured other cheques, which, but for the wrong payment could have been
honoured. In this case what happened was the customer gave the wrong number while instructing the banker to stop
payment. Subsequently the bank aid the cheque which the customer intended to stop, identical in all details but
bearing a later number, presuming it to be a duplicate. The decision was in favour of the bank. It was observed “when
it comes to a question of identification it must always be remembered that the number of cheque is one certain of
identification. There can be only one cheque bearing a printed number, there may be many cheques in favour of the
same payee and for the same amount”.

        So the banker is safe is he gets the number of cheques for stopping payment. He should also not act until he
receives confirmation in writing of stop instruction given over phone or by telegram.

        2. There can be no constructive countermand of payment. In Curtice V. London City and Madland Bank Ltd.
(1908) a customer sent the ‘stop instruction’ by telegram. This was received after he bank hours and was placed in
the bank letter box. The next morning, the box was not properly cleared and the cheque and the cheque was paid
before the telegram was noticed. Held there can be no constructive countermand of payment. There can be no
stopping of cheque unless it actually comes to the bank’s notice. Of course there was negligence in not properly
clearing the letter box, but that would entitle the customer only to nominal damages.

        3. In the case of stops by telegram or telephone the banker should act carefully. He can only postpone
payment and cannot refuse payment. To write the answer on such a cheque “payment is stopped” is unwise and the
banker faces trouble if the message happens to be a hoax played on the banker. So a better answer would “Payment
countermanded by telephone/telegram, confirmation awaited”. Even where the instruction is confirmed it is not good

to use the words “payment stopped” which may mean, the drawer has become insolvent or the paying banker has
suspended the payment. Better answer would be “orders not to pay” or “Payment countermanded by drawer”.

         4. The customer has the right to stop payment any time before the money is actually handed over to the
holder in the case of an open cheque (Chamber V. Miller). In the case of cheques passing through clearing, the
instruction is effective if required before the instrument is cleared.

         5. Payee of a cheque has not right to countermand. It is only the drawer who has the right to countermand.
Therefore payee should contract the drawer in the case if cheque is lost or stolen. It is not safe for banker to act on
the instruction of payee. However depending on the status of the payee and the other circumstances, the banker may
postpone the payment.

       In the case of executors, trustees or partners or joint account holders, it is sufficient if any one of them
countermands. However it is advisable for the banker to obtain such authority for them at the time of opening the

        6. When the customer has more than one account with the same branch, stop instruction must be noted
against all accounts.

       But when the accounts are kept at different branches, the customer must specify the branch on which it is
drawn. But if the banker pays the stopped cheque at some other branch in spite of the correct instructions of the
customer, the bank will have to suffer the loss (Burnett V Westminster Bank Ltd)

2. Notice of death, insolvency or insanity of his customer or in the case of company notice of its winding up:

          1) Death: The bank should not honour customer’s cheques after receiving he notice of his death. Notice may
be formal given by some one interested of constructive as for example the news in the paper. Death also cancels
authority given to agents and others, but any contracts in the course of completion should be completed and cheques
drawn to fulfill such commitments can be paid. In the case of joint accounts there is no need to stop the account, even
if one of them is surviving. Cheques drawn by a deceased director of company against the company’s account can
still be paid, as he signed it only in the capacity of an agent.

         2. Insolvency: In England, cheques drawn payable to self, or third parties can be paid, before the banker
receives notice of an act of bankruptcy. With regards to cheques drawn after the receipts of notice, but before the
presentation of petition, the banker should make a distinction between self cheques and cheques drawn in favour of
third party. The former can be paid but not the latter. But in Re Dalton (1962) the learned judge pointed out that it was
ridiculous to permit payment to the customer, so that he could pay the creditor is he so chooses. But dishonour a
cheque drawn directly in favour of the creditor. In the case of debit accounts, any further payments after the notice of
bankruptcy cannot be recovered from the trustee.

        The law in India is less stringent and the banker can pay cheques up to the time he receives the notice of the
presentation of petition. He need not stop cheques simply because the customer has committed an act of insolvency

        3. Insanity of customer: Where a banker receives notice of a customer’s mental disorder, his authority to
pay cheques and also to act upon customer’s mandate given to agents and others is terminated. If there is a clear
proof of mental incapacity such as doctor’s certificate or a court order, the bankers face no problem. Otherwise
honouring or dishonouring may land him in trouble. If he presumes insanity and dishonours cheques, he may have to
pay damages to latter, if the presumption is proved to be incorrect. If he presumes sanity and pays the cheques, he
may lose right of debiting customer’s account.

3. Notice of Assignment of Credit Balance:

        The credit balance in the account of a customer may be assigned (or transferred) by him to another person
under Section 130 of the Transferor or Property Act, 1882. On receipt of a notice of such assignment, the banker
must stop payment of the cheques drawn by the assignor, as the latter ceases to be the owner of such funds.

4. Garnishee Order:

       As already noted, a banker is bound to comply with the order issued by the Court restraining him from paying
the money from a customer’s account. He must refuse payment of the cheque presented after the receipt of a
Garnishee Order of any other order of the court attaching the customer’s money.

5. Beach of Trust:

        If the banker comes to know that the customer, who is operating a Trust account, contemplates to use the
funds of the Trust account in breach of trust, the banker must stop payment of the cheques drawn on such account.

6. Defective title of the party:

         If any person presenting a cheque has defective title to the cheque and the banker is aware of this fact, he
can refuse to honour such a cheque without any risk, because if he makes payment of the cheque to such person, it
will not be made in good faith and the payment will not be deemed as payment in due course. This applies to bearer
cheques as well, because if the banker has reason to believe that the presenter may/may not be the proper person to
receive payment, he may insist on the identification of the presenter of the cheque, so that the payment is deemed as
payment in due course.

7. Bank will be justified in refusing payment of the cheques in the following circumstances:

        i) if the cheque is a post-dated cheque or a stale cheque

        ii) if the cheque is drawn on another branch of the same bank,

        iii) if the cheque contains an apparent material alteration which is not properly authenticated by the drawer.

        iv) if the signature of the drawer is a forged one or does not tally with his specimen signature

        v) if the funds of the customer in his hands are not sufficient or are not properly applicable to the payment of
such a cheque. For example, if a banker exercises his right of set-off for recovering a loan, the funds in the
customer’s account may be insufficient ot honour the cheque. But it is necessary that the banker should give proper
notice of his action to the customer before the stops payment of cheque. If there are sufficient funds in another
account of the same customer, banker himself cannot transfer funds from one account to another and can dishonour
the cheque for want of funds.


                                                     LESSON – 25

                                                COLLECTIVE BANKER

       Collection of cheques crossed and uncrossed for his customer was stated as one of the important functions of
a bank, in the definition of Bank given by Sir John Pager. It is now widely recognized as an implied term in the
banker-customer relationship. In this role the banker is referred to as the collecting banker.

Procedure for Collection

        After a cheque is received from the customer, the collecting banker must present the same to the drawee
bank within a reasonable time. What is reasonable time depends on the circumstances in each case. If it is a local
cheque it should be presented on the same day or at least the next day. If the cheque is received late after clearing
hours, the customer is informed by stamping the “Pay-in-slip” with the words “Too late for today’s clearing”. In the
case of outstation cheques, i.e., cheques drawn on a bank in a different town, the same should be forwarded to the
branch of he bnak or if it has no branch to its agent or correspondent, the day after receipt. If the cheque is not so
presented either by the banker or his agent within reasonable time, as a result of which the customer suffers any loss,
the banker will have to make good the loss. The customer may suffer loss either because of the failure of the drawee
bank or the drawer of the cheque becoming insolvent.

         When a cheque is dishonoured, notice of dishonour must be given to the customer by collecting banker.
Rules of the account provide that such a notice will be give by the bank on the business day following the receipt of
the unpaid cheque by the bank. Notice of dishonour is given by returning the cheque together with objection memo
giving the reason for dishonour. Notice of dishonour is to be given to all the previous parties to the instrument against
whom the holder wants to proceed. But where the collecting banker is only acting as an agent and not as a holder for
value, notice is given to the customer who in turn will give the necessary notice to others. But where he is a holder for
value he has to give notice to all the parties against whom he wants to proceed.

Risks in Collection

         In the collection of cheques, the collection banker is exposed to serious risks. In law there is a concept called
‘Conversion’ Conversion is unauthorized interference with another person’s property inconsistent with the owner’s
right of possession. Any person who however innocently, obtains possession of the goods of a person who has been
fraudulently deprived of them and disposes of them whether for his own benefit, or that of some other person is guilty
of conversion.

         The plea of innocence is of no avail in actions concerning conversion nor the plea that the person charged did
not derive any benefit from it. This principle applies to tangible goods only and not debts. (chose-in-action). But in the
case of Negotiable Instruments there is the material part representing the paper on which the instrument is written
and the debt part. Although the material part of the instrument may not be of much value, the Courts have always
allowed the full value the instrument represents, in suits for damages for the conversion of instrument.

         Therefore when the bankers collect cheques belonging to other persons, there is the risk of true owner of the
instrument proceeding against the Bank for conversion, whenever the customer’s title to the instrument is defective. It
is also usual for the true owner to join with his claim for conversion, a claim for money had and received. There is an
implied promise which the law imputes to a person dealing with the money of another, to repay that money to the
lawful owner when it is demanded and such implied promise is the very basis of the claim. If X receives payment of a
cheque bearing a forged endorsement of Y who is the true owner, Y can claim the amount of the cheque from X
whom Y may treat as his agent. A national contract of agency is assumed and suit filed by the owner is similar to that
filed by a principal against his agent to recover the money received on behalf of his principal.

Need for Statutory Protection

         We have seen earlier the risks that the collecting banker has to face when engaged in the collection of
cheques. In the case of crossed cheques they have to be collected only through a banker. There is not other
alternative. When that is the case it is unfair to subject his to the risks in such collection. Every time he receives a
cheque for collection, it is impossible for him to find out whether it contains a forged endorsement or not. Therefore
unless he is given the statutory protection it is not possible for him to carry on his business.

Statutory Protection

Section 131 of the Negotiable Instruments Act., 1881 which governs the protection given to the collecting banker in
India runs as follows:

         “A banker who has in good faith and without negligence received payment for a customer of a cheque
crossed generally or specially to himself shall not, in case the title to the cheque proves defective, incur any liability to
the true owner of cheque by reason only of having received such payment”

        Here again as in the case of Paying Banker, the protection given to the banker is conditional. They are

          1. The protection is for crossed cheques only: In the case of open cheques, the collecting banker has to
still face the risk, in case it bears a forged endorsement because the protection is only for crossed cheques. It should
be noted that the crossing must have been done before it reached the hands of the banker.

        2. He must receive payment for a customer only: A banker can claim protection only in respect of cheques
collected for his customer.

        3. He must have received payment in his capacity as agent of the customer: Protection is available to
the banker, when he collects cheques as agent without acquiring personal interest or in the capacity of a holder for
value. A practical difficulty was encountered by bankers both in England and India whose practice was to credit the
customer’s account before collecting cheques. To credit customer’s account with amounts of cheques as cash in
deemed to be equivalent to taking a cheque as transferee for value and the legal effect is same when a customer is
allowed to draw against a cheque lodged with the banker for collection. But their difficulty was removed by adding
Explanation to Section 131 of the Negotiable Instruments Act. It reads “a banker receives payment of a crossed
cheque for a customer within the amount of the cheque before receiving payment thereof”. But when a banker takes a
cheques as an independent holder by way of endorsement, i.e., if he gives cash against a cheque over the counter,
the protection is lost in regard to the collection of his cheque.

         4. He must act in good faith and without negligence: This stipulation refers to the whole conduct of the
banker during the entire period of the transaction, i.e., from the time of receiving the cheque for collection till it is
credited to the customer’s account. The burden of proving good faith and absence of negligence is on the banker,
claiming protection (Brahma Shamsher Jung Bahadur V. Chartered Bank of India). Generally good faith is presumed
in the case of bankers and the collecting banker is likely to lose protection only because of negligence.

What is ‘Negligence’ on the part of the Collecting Banker

         This has been stated by Lord Dunedin in Commissioners of Taxation V. English Scottish & Australian Bank
Ltd. (1920). The test of negligence for a banker “whether the transaction of paying in any given cheque coupled with
the circumstance antecedent and present was so out of the ordinary course that it ought to have aroused doubts in
the banker’s mind and caused them to make enquiry”

        Negligence depends upon the circumstances of each case. Generally speaking negligence indicates lack of
care which is necessarily to be taken in any circumstances. In Central Bank of India Ltd., Bombay Vs. V. Gopinathan
Nair and Others, the Kerla High Court observed that:-

          “The test of negligence under Section 131 is whether the payment considered in the light of the
          circumstances, antecedent, and present, was so much out of ordinary course that it ought to have aroused
          doubt in banker’s mind and caused him to make enquires”
          For example, if the circumstance of case create doubt or suspicion about the right of the customer to the
cheque, the banker must make enquires and take adequate precautions, Failure to do so will constitute negligence on
his part.

          It must be carefully noted that ordinarily a banker owes duty to his own customer but the law makes him
responsible to the true owner of the cheque also. Thus the privilege of statutory protection can be availed of by the
banker if he fulfils his statutory duty towards the true owner of the cheque and exercises due care in safeguarding the
latter’s interest.

        Examples of negligence: A collecting banker loses statutory protection on the ground of negligence on his
part. Examples of such negligence are as follows:
          1. Failure to Obtain a Satisfactory Introduction or Ask for Reference and Checking Them Before
opening an Account: All banks today have made a rule, to which there is no exception, to require a satisfactory
introduction or a reliable reference for all persons proposing to open current accounts. Apart from the desirability of
knowing that the person to whom the cheque books is to be issued is not of dubious honesty, the banker would
certainly be negligent if he fails to as for introduction/reference and there would be no statutory protection if the
customer passes through his account cheques to which he has no title. It should be noted that obtaining and checking
introduction/reference is an essential stage in the process of opening an account unless the applicant is already
known to the bank. If the banker asks for and follows up a reference and receives a satisfactory reply, he will have
fulfilled his duty of care in this respect.

In Ladbroke & Co. V. Todd (1994), a thief opened an account with a stolen cheque, professing himself to be the
payee. The thief was not introduced to the bank nor did the bank ask for any reference. The cheque was specially
cleared on the request of the thief, followed by the withdrawal of the money and disappearance of he thief. The
drawer sent another cheque to the payee, took an assignment of his rights in the stolen cheque and sued the bank,
which was held to have been negligent in not taking reasonable precautions to safeguard the interests of persons
who might be the true owner of the cheque-in other words in opening an account with a total stranger.

       It will be noticed that in the above case the bank no step at all to investigate the position or character of their
new customer.

       2. Irregularity of endorsements: The collecting banker should verify the correctness or regularity of he
endorsements on the order cheques. For example:

         a) If the collection banker fails to note that the endorser has not signed his name in the same manner or
spelling as appears in the name of the payee (or endorsee), the endorsement will be held irregular;

       b) if two or more endorsement on a cheque are in the same handwriting, their genuineness may be easily
doubted and enquiry should be made. Failure to do so will constitute negligence on the part of the banker; and

        c) If the banker does not verify the authenticity of the authority of the person who signs per procuration, he will
be held negligent.

        3. Failure to credit a Cheque Payable to a Company to That Company’s own Account: Since it is
unusual for companies to negotiate cheques made payable to themselves, to others, and since it is the banking
practice to credit such cheques to the company’s own account, it is considered that a banker who deviates form the
established banking practice without making enquires and obtaining satisfactory explanation would be negligence
unless he knew of special arrangements, e.g., between allied companies, for such practices.

        4. Crediting Cheque Payable to a Company to the Private Account of an Official of the Company: It is
now the recognized practice of banker to refuse acceptance of a cheque payable to a limited company for the credit
of an individual’s account without enquiry. It follows that if such a cheque is accepted for a private account, and is
afterwards found to have resulted in conversion by the customer, the statutory protection will afford no defence for the
banker. This applied even where the banker knows that his customer is acting within his delegated authority in
endorsing the cheques, but the circumstances are such that should be sufficient to arouse suspicion.

        5. Crediting a Private Account of an Agent or Employee with Cheques Drawn by him on Account of
his Principal or Employer. This point is illustrated by the following two cases:

        In Midland Bank V. Reckitt (1933), the bank collected cheques drawn by Reckitt’s attorney for credit of the
attorney’s personal account in reduction of an overdraft. The bank was held to be negligent in collecting cheques
without enquiry for a private person which had on its face evidence of being intended for someone other than the
customer in question.

       In Souchettee Ltd. V. Landon Country Westminister and Parrs’s Bank Ltd. (1920), a customer, who was
managing director and secretary of a limited company, paid into his private account cheques drawn by the company
payable to the order of one of its creditors.

        The bank knew of the relationship in which their customer stood to the company but no enquires as to why
the cheques of this description, payable to a third party, were being thus used, were held to have been negligent.
       6. Crediting an Agent’s Private Account with cheques payable to him in his capacity as Agent when it was
apparent that they intended for His Princial.

         7. Crediting Cheques Payable to the Holder of a Public Office to his Personal Account: If the fiduciary
capacity of the payee or endorsee is apparent from the form of the cheque, the banker should not accept the cheque
for a private account without first making careful enquires. It would be negligence for a banker to take for private
account cheques payable to tax collector, excise officials and the like under their official denominations.

        8. Crediting Cheques in favour of a Trust, Whether crossed or uncrossed, to the Trustee’s (or Executor’s)
Private Account. The banker must not put through such transactions otherwise he will make himself liable for any
misappropriation on grounds of negligence.

         9. Crediting a Cheque Drawn by a Partner in a Firm, in accordance with the authority given, payable to
himself, into such Partner’s Private account.

         10. Collecting a Cheque payable to a Limited Company for the Account of another company without
satisfactory explanation: It is unusual for corporate bodies to endorse over cheques, whether generally or specially.
As such, the only prudent course is for bankers to refuse to accept, without enquiry or special instructions, cheque
made payable to companies for accounts other than those of the payee.

        In London and Montrose Shipbuilding and Repairing Company Ltd. V. Barclays Bank Ltd. (1926), the named
payees was a limited company and the cheque had been endorsed by that company to an endorsee; it was held that
there was clear evidence of negligence as the bank collecting on behalf of he endorsee was put on enquiry but no
action was taken.

         11. Collection Without Satisfactory explanation cheques for amounts inconsistent with its customer’s
activities: The banker should watch the general state of account for which the cheque is being collected, since this
may lead to certain transaction prompting enquiry, as when large cheques are suddenly paid in for collection for a
small account kept by the customer who is not particularly well-to-do. Operations of an abnormal character on an
account of a kind that should reasonable provoke comments, will be regarded as evidence of negligence, if they pass

12. Collecting without satisfactory explanation third party cheques where the customer has previously
proved to be Unreliable: In the under noted case, enquires were made where the circumstances were suspicious,
but the court held that such enquires were not sufficiently through.

        In Motor Trader Guarantee Corporation Ltd. V. Midland Bank Ltd. (1937), the plaintiff had issued a cheque in
favour of a firm of motor dealers and handed it to a man who was to use the cheque to purchase a car for himself
which the plaintiff were financing under a hire-purchase agreement. The payee’s signature was forged and the
cheque paid into the man’s own account. The cahier queried the transaction but was given a plausible explanation
and accepted the cheque for collection. The bank’s regulation required such transactions to be dealt with by the
manager and not by a cashier, which was not done in this case. The customer’s banking history was unsatisfactory –
a large number of cheque having been dishonoured for want of funds. It was held that the bank should not have
accepted the cheque without closer enquiry than was made by the cashier, and that the bank was guilty of

         13. Collecting cheque having No Endorsements or Having Manifest Irregularities in Endorsements: In those
cases where endorsement is required or it is the practice of bankers to require endorsements, bankers have to verify
the regularity of endorsement on order cheques handled by them as paying or collecting bankers. In paying or
collecting cheques with irregular endorsements, banks may be found guilty of negligence and thus lose the statutory
protection available to them.

         14. Collecting cheque for a Customer’s Account drawn by him “per pro” or by him and another on behalf of his
firm or his principal and made payable to himself.

       15. Omission to Verify the Authority when cheques are endorsed by an employees or agent “per pro” and are
tendered for credit to his private account.

         16. Disregard of “Account Payee” Crossing: Though this crossing has no legal significance, yet if a banker
credits such a cheque to an account other than that of the payee, without making proper enquires, this may constitute

Duties of the Collecting Banker

       The collecting bank acts as an agent of his customer and is responsible to him for his acts of omission or
mistakes. The duties of a collecting banker towards his customer are as follows:

         1. Presentation of cheques for payment within reasonable time: The banker should collect the cheques, sent
by the customers, with due care and should present the cheques to the drawee bank within a reasonable time.
According to the practice followed by bankers if the collecting and paying bankers are in the same place, the
collecting banker should present the cheque the next day after he receives it. In case of outstation cheques, he
should dispatch the same to the drawee banker on the day after it is received by him. The cheque may also be
presented thorough a clearing house or through the post.

       Sections 72 and 84 lay down the consequences of non-presentation of cheque before the drawee bank within
a reasonable period of time. If a cheque is presented with undue delay and in the meanwhile the drawer of the
cheque suffers damages, the drawer is discharged to the extent of such damage.

        According to Section 84(1), “Where a cheque is not presented for payment within a reasonable time of its
issue and the drawer or person on whose account it is drawn had the right, at the time when presentation ought to
have been made, as between himself and the banker, to have the cheque paid and suffers actual damage through
the delay, hs is discharged to the extent of such damage, that is to say, to the extent to whch such drawer or person
is a creditor of the banker to the larger amount than he would have been if such cheque had been paid” The
reasonable time for this purpose shall be determined having regard to :

        i) the nature of the instrument,
        ii) the usage of trade and of bankers, and
        iii) the facts of the particular case.

         When the drawer of the cheque is so discharged, the holder of the cheque shall be the creditor of the banker
to the extent of such discharge and shall be entitled to recover the amount from his under Section 84(3).

If the collecting banker presents a cheque before the drawee bank with undue delay on his part and the cheque is
dishonoured, the collecting banker shall be liable to reimburse the loss suffered by his customer in any of the
following ways:

        i) If the collecting banker fails to present the cheque to the drawee banker within a reasonable time, and in the
meanwhile the latter fails, the collecting banker will be liable to reimburse his customer in respect of the loss caused
to him due to the failure of the drawee bank because the collecting banker was negligent in presenting the cheque in

         ii) If the drawer of the cheque himself becomes insolvent during the period the cheque remains with the
collecting banker, the latter is liable to reimburse his customer.

         iii) If the banker does not employ the normal and usual channel of collection of cheque and thereby payment
is received with delay and in the meanwhile a cheque drawn by the customer is dishonoured, the customer will be
entitled to recover damages from the collecting banker.

         2. Notice of Dishonour: Similarly, the collecting banker is required to show the due diligence in informing his
customer about the dishonour of a cheque. The customer can then proceed to recover the amount from the parties
liable on the cheques. The rule applicable to the collection of cheques is applicable to the notice of dishonour also.
Even where a cheque is dishonoured on presentation but before the presenting banker has had time to return it to his
customer, it is reclaimed and paid, the banker should inform his customer about it as it may help him in assessing the
drawer’s true financial position.

                                                        LESSON - 26

                                               SERVICES TO CUSTOMERS


         A modern banker offers a wide variety of financial and non-financial services to his customers and to the
public in general in addition to the two essential functions of accepting deposits and extending credit. As the
maximum rates of interest that can be offered by the banks in India on various types of deposits are uniform and
governed by the directives of the Reserve Bank of India, they can no longer complete by offering higher rate of
interest. Banks are obliged to devise new schemes and services to overcome the increasing strain on profitability.
Further, developments in the ways in which banks acquire funds and make them available have been accompanied
by important changes in payment mechanism in recent years.

         For the past some years commercial banks in India have been adopting the strategy of “innovative banking”
in their business operations. Innovative banking implies the application of new techniques, new methods and novel
schemes in the areas of deposit mobilization, employment of credit and bank Management. Banks are becoming
more and more innovative and are tying to enlarge the range of new services by covering more areas of usefulness to
their customers and to meet the growing needs of the community. Some of these services are of specialized nature
which call for employment of experienced and expert staff.

            In this chapter we shall deal with the following important services and facilities provided by a modern banker
in India:

       1. Remittance of Funds
       2. Safe Deposit Lockers
       3. Safe Custody of Articles
       4. Standing Instructions
       5. Other Bank Services (Financial and Non-Financial)
Remittance of Funds

         Commercial banks are eminently suited for remittance of funds from one place to another through the network
of their branches spread over the entire country. The main instruments for transfer of funds through banks are bank
drafts, mail transfers, telegraphic transfers and traveler’s cheque of which the bank drafts are by far the most popular.
Similar instruments are also used in making overseas payments in a wide range of foreign currencies and are drawn
on overseas branches or correspondent banks.

Bank Draft

        For remitting money from one place to another banks issue demand drafts (popularly called bank drafts or
simply drafts) on their branches at the place of estimation. It is issued on request to customer who has to make a
guaranteed payment, that is, in circumstances where the payee wishes to be certain that the cheque will be paid upon
presentation. After cash, the next best thing is a bank draft which avoids the necessity of having to carry sums of
money to effect a payment.

        Section 85A of the Negotiable Instruments Act, 1881, defines a bank draft as “an order to pay money drawn
by one office of a bank upon another office of the same bank for a sum of money payable to order on demand”.

         A bank draft is, thus, a payment instruction similar to a cheque and is always drawn by one branch on another
to pay a specified sum of money to the person named therein or his order. A draft is always payable on demand.
Bank draft must not be payable to bearer on demand since they would be equivalent to bank notes which by Section
31 of the Reserve Bank of India Act. Cannot be issued by any person other than the Reserve Bank, or, as expressly
authorized by this Act, the Central Government. An order drawn by a bank upon its current account with another bank
is not a draft in law but is a cheque.

Mail Transfer (MT’s)

       A mail transfer is, in form, a request addressed by one branch of a bank to another branch to pay a stated
sum of money to a names party and, as the name implies, the instructions are sent by mail duly authenticated under
authorized signatories. The remitter deposits the amount plus a small commission for the service with the remitting
branch. On receipt of the MT, the receiving branch will either issue its own pay order in favour of the beneficiary which
he can collect either through a bank or directly by establishing his identity, or, alternatively, make payment to the
beneficiary’s account with itself or with another branch. Transfer payment system avoids certain disadvantages of
cheques and banker’s draft as instruments of making payment.

         MTs are generally issued for mail remittances for i) credit to customers’ account at the receiving office; ii)
transferring a deposit account from one office to another office; iii) payment to third parties; iv) other inter-branch
transactions such as remittance of proceeds of bills, reimbursement of expenses, etc. A mail transfer being an
arrangement between two bank offices, is not a negotiable instrument.

         Mail transfers are effected no only for remittances within the country but also for international remittances.
The purchase for the MT pays funds in domestic currency on the date of purchase but the beneficiary gets payment
at the foreign centre only after receipt of the MT. The account of the selling bank is not debited with the amount until
arrival of the MT though it received funds at the domestic centre on the day of the sale. This results in gain of interest
to the selling bank for the intervening period and a corresponding loss of interest to the purchaser. The    purchaser
is compensated for the loss of interest Mt rates cheaper than TT rates. However, in India, MT and TT rates are
quoted at the same rate. Mail transfers are confined almost to transactions for small amounts which are carried out by
main in order to save cable express.

        A mail transfer for remittance of money to a foreign country can be sent either by air mail or by sea mail. The
normal practice not is that mail transfers are dispatched by air and so mail transfers have become air mail transfer.
Moreover, MT’s are advised in duplicate by the issuing bank by separate mail, so that there is no risk of going astray
and since they are dispatched on the same date, there is no delay.

        As regards delay in inland transfer of money, the Reserve bank of India has issued a series of instructions to
the banks stating that the customers should get credit for remittances of money through the facility of bank mail
transfers within a maximum period of seven to ten days from the date of application. This would specifically benefit
borrower-clients of banks who send mail transfer for loan repayment purposes and incur interest on such loans
(Hindustan Times, dated 19 December, 1988).

Telegraphic Transfers (TTs)

         A T.T. is similar to mail transfer except that the transfer is effected by telegram, telephone or telex as desired
by the remitter and the remittance charges are higher than those for bank drafts and MTs. In fact, this is the most
expensive and also the most rapid and convenient method of transfer of funds from one centre to another. Like a mail
transfer, a TT is an arrangement between two bank offices or with a correspondent, and is not a negotiable

         There is little risk that telegraphic message will be delayed or fail to reach its destination since most banks
operate a system of sequential or other check numbers to determine whether a particular message is missing. The
genuineness of the payment instructions is verified by an elaborate key system which immediately reveals any error
that may have been made either in the amount to be paid or in the name of the beneficiary. Unless the test agrees
exactly, the remitting branch is asked for confirmation.

         In the case of foreign remittances, since a TT involves payment of foreign funds on the same day as the
receipt of domestic money at the local centre no capital risk or loss of interest or stamp duty, as used for a bill of
exchange, is involved. For this reason, the TT rate is costlier as compared to any other form of remittance. The rate of
exchange for the banker’s TT is considered the basic rate between two currencies and the rates of all other methods
of remittance are arrived at by adjusting the TT rate on making allowances for loss of interest, cost of additional
service rendered by the bank, etc.

Travellers’ Cheques

         Travel facilities from part of the banks’ services. Travellers’ cheque provide a safe way of carrying money
while traveling both in the home country or abroad         . The bigger Indian banks supply travellers’ cheques in
Indian rupees and internationally traded currencies like US dollar and pound sterling; they are also available in the
Common Currency denomination of the European community-the ECU (European Currency Unit). They are for fixed
amounts such Rs. 10, Rs. 50, Rs. 100, and the foreign currency travelers cheques can be en-cashed at the current
rate of exchange. Travellers’ cheques in foreign currencies can be purchased, subject to exchange control regulation
from a number of Indian banks, from leading international banks such as the Bank of America and the First National
City Bank or their agents and correspondents and from local agencies like the American Express Company.

        Travellers’ cheques can be purchased for their face value at a small commission which may be built in the
exchange rate of the travellers cheques in foreign currencies. Travellers’ cheques are signed by the holder when they
are issued, at the bank he is required to pay for them. When they are to be cashed, the holder countersigns them in
the presence of the authorized official of the agency enchasing the cheque, who compares the signature to see that
they correspond, before making the payment, and this also facilitates identification. Airlines, shipping companies and
railways, large hotels and stores may accept travellers’ cheque in lieu of cash payments and banks generally are
prepared to en-cash travellers’ cheques at a small discount.

        Travellers’ cheques normally take two forms: either they are in the form of a pay order drawn by the issuing
bank on itself or they contain an order from the purchaser to the issuing bank. In either case they are made payable
to the order of a payee to be named. The space for payee’s name is generally left blank at the time of issue of
cheques and it is inserted when they are encashed. Alternatively, the holder may write his own name as the payee
and he will have to endorse the cheque at the time of encashment.

        Travellers’ cheques provide greater safety than currency. If currency notes are lost or stolen, little can be
done about it. Banks issuing travellers’ cheques, however, are usually prepared to replace them or to refund the face
value of those missing.

Safe Deposit Lockers

         Certain bank branches in the metropolitan cities and important towns provide safe deposit locker facility
whereby a customer can rent a safe deposit locker in a specially built locker cabined placed in the bank’s safe deposit
vault/strong room. Lockers are convenient repositories for jewellery, documents and securities; the articles will be
kept by the customers in the lockers themselves and the bank has no idea of their contents. The main outer door of
the safe deposit vault/strong room has a double lock and the two keys are separately held by he bank officers for dual
control. The customer is allowed access to the vault during the prescribed business hours. Every bank has its own
rules governing the lockers and the renters should abide by all such rules and regulations.

         There are two locks to each locker, one key being kept by the customer and the other by he banker for dual
control. The key used by the vault attendant (custodian) is always referred to by some terms such as “guard key” or
“preparatory key”. The words “master key”, “bank key” or “pass key” may imply that such key will open ay box in the
vault whenever such a term is used by a customer. It should be explained that it is called the “guard key since it
cannot unlock any box but simply sets the lock so that the customer’s key will unlock the box”. Duplicate keys are
held by the bank but would only be used incase of emergency in the presence of the customer at his request.

Commercial Letters of Credit

         In international trade there is the peculiar problem of distance and unfamiliarity between parties concerned
viz., exporter and importer. Before sending the goods, the exporter must be satisfied with the credit worthiness of the
importer. If the importer fails to pay the price, the exporter will find it difficult or too costly to recover the amount.

        The importer is generally request to open a letter of credit with a certain bank having branches in both the
importing and exporting countries. Thus the importer has to rove his credit worthiness to the foreign exporter by
obtaining a letter of credit and sending the same to the foreign dealer.

Definition of a Commercial Letter of Credit

        A Commercial Letter of Credit may be defined as “an order addressed by a commercial house (usually a
banker) to the agent or correspondent or branch in another place instructing the latter to honour bills or drafts or
cheques drawn upon him by a beneficiary (usually the exporter) named and identified (generally through specimen
signature) in the letter of credit upto a stated amount and within a stated period of time”.

        The letter of credit also contains the terms and conditions, if any, under when the payment is made to the
beneficiary. It was been held in Orr and Barter Vs. Union Bank of Scottland (1854) that a letter of credit is not
negotiable instrument. Hence the paying banker must exercise great care about the identity of the beneficiary.

        Letter of credit are classified on different basis. The Various types of letters of credit are discussed below:
1. Documentary and Clean Letters of Credit

         A clean or open letter is a letter of credit which neither stipulates any conditions for payment to the beneficiary
not calls for any security from the person at whose request it is opened. It is opened only in the case of parties of
sound financial position.

         If a letter of credit lays down the conditions that the documents of title to goods should be attached to the bill
of exchange drawn under it, it is a documentary or secured letter of credit. The interests of the banker who opens the
letter of credit are safe-guarded this way, as the documents of title to goods provide security to him, if the importer
makes default in payment.

2. Fixed and Revolving Letters of Credit

        If a letter of credit specified the amount upto which the beneficiary can draw bills of exchange within the
specified period of time, it is a fixed letter of credit.

          A revolving letter of credit is one where the amount of credit reverts back to the original amount after such
amount has been paid on presentation of the bill. In a revolving letter of credit the amount upto which bills drawn may
remain outstanding at a time is mentioned and not the amount upto which the bills may be drawn. So the beneficiary
or exporter can draw fresh bills as soon as the old bills are paid for. This type of letter of credit is more advantageous
to the exporter because he is entitled to draw bills of a higher amount within the specified period than in the case of a
fixed letter of credit.

3. Revolving and Irrevocable Letters of Credit

        A revocable letter of credit is one which can be cancelled or withdrawn by a banker without notice and without
the consent of the beneficiary. But the banker has to give a notice of cancellation to the beneficiary, if there is a
provision in the letter of credit that the bill drawn prior to the cancellation should be honoured.

        In the case of an irrevocable letter of credit, it cannot be cancelled without the consent of the beneficiary.

4. Confirmed and Unconfirmed Letters of Credit

        When the paying bank in the exporter’s country adds its confirmation to the letter of credit, it becomes a
confirmed letter of credit. The confirming bank becomes a party to the undertaking that the bills drawn by the
beneficiary will be honoured. A confirmed letter of credit is always an irrevocable letter of credit, as it cannot be
revoked without the consent of the confirming bank and the beneficiary.

        If the paying bank does not add its confirmation, the letter of credit will be an unconfirmed one. The paying
bank will be under no obligation to hounour the bills drawn by the beneficiary in this case.

5. Transferable and Non-transferable Letters of Credit

         If the beneficiary is given the right to transfer his power of drawing bills to some one else, under a letter of
credit, such a letter of credit is knows as a transferable letter of credit. Even the total amount of credit can be divided
into more than one part and each part may be transferred to a different person. Transferable letters of credit are
normally issued when the beneficiary is only an intermediary and not the exporter.

        A letter of credit under which the beneficiary has no right of transfer of his power to draw bill is non-
transferable letter of credit. If a beneficiary requests the banker to open a new letter of credit in favour of some other
persons on the security of the non-transferable letter of credit and the same is done, such a letter of credit is known
as a Back to Back letter of credit.

6. “With” and “Without Recourse” Letter of Credit

         In the case of a letter of credit ‘with recourse’, the banker can recover the amount of the bill form the drawer
(usually the exporter) if the drawee of the bill (usually the importer) fails to honour, i.e., the banker has recourse to the

drawer. The drawer or exporter may prefer a letter of credit ‘without recourse’ under which the banker has no
recourse to the drawer.

Advantages of a Letter of Credit

        The advantages of a letter of credit may be analyzed under two heads.

      1) Advantage to the beneficiary or exporter, and
      2) Advantages to the Importer
Advantages to the Beneficiary

        1) Assured payment and absence of Risk:

          The beneficiary is assured of payment as the banker is bound to honour the bills drawn by him under the
letter of credit. The financial standing and reputation of the opening banker (and also confirming banker in the case of
a confirmed letter of credit) provide absolute security against any risk of dishonour:

        2) Ready Negotiability: The exporter, if he wants can secure the payment immediately by discounting or
negotiating the bills drawn by him under the letter of credit with the confirming banker or some other banker. In the
absence of the letter of credit, it may not be possible for the exporter to get the bills discounted on the strength of his
own financial standing counter-indemnity so that in the event of failure to complete the contract and a requirement for
payment under the terms of bonds, it will be able to make a claim against the contractor. This counter-indemnity may
be backed by some from of security given by the customer.

Financial Guarantees

         It sometimes happens that customers need the guarantee of a bank before being allowed to undertake
certain actions. For example, it may be necessary for an exporter to raise funds in foreign currency for financing his
operations in connections with an export project. In such a case, the financing institution abroad may need a bank
guarantee to be furnished by the exporter in accordance with international practice. To void the risk of possible future
loss, apart from obtaining export performance guarantee of ECFC if available, the customer will be asked to give a
counter-indemnity if the bank is willing to comply with his request. In his way if the bank has to make a payment to the
foreign institution abroad, it will itself have a claim against the customer.

Standing Instructions

         Banks perform another subsidiary service for their customers and accept standing instructions form them
either to make periodic payments, collect monies, or effect transfer of money on stipulated dates, on their behalf
either for a limited period or until further notice. The bank will automatically do this by debiting payments or crediting
receipts to its customer’s account.

        Some of the common standing instructions received by banks from their customers are given below:

        1. Transfer of funds from one account a another
        2. Payment of insurance premiums to LIC
        3. Membership subscription to clubs, libraries, professional associations and institutions.
        4. Periodic remittances on customer’s account to another account at the same branch, or to another branch
           or another bank or by money orders.
        5. Collection of dividends on behalf of customers.
        6. Collection of interest on G.P. Notes held in safe custody or otherwise
        7. Collection of pensions on behalf of account holders.

          Such instructions which are obtained from the account holder in writing must be clearly worded and
unambiguous. The banker may not accept standing instructions which are difficult to comply with, but once accepted,
it is the duty of the bank to carry out the instructions carefully and promptly. If a small branch is unable to carry out
certain instructions by itself, it may sometimes accept them, and put through one of bigger branches or though the
Head Office.Once the standing order mandate has been accepted, no further action is required by the customer
beyond ensuring that necessary funds are in his account on the specified date. If the standing instruction is of open-
ended type, it is the responsibility of the customer to ensure its cancellation at the appropriate time; otherwise the
bank will continue to make the payment to the payee.
Credit Cards

        Credit Cards are issued by banks as a method of payment without the use of a cheque. They provide a
means of obtaining goods and services immediately but paying for them later. Each card holder is given a credit limit
on his credit card account. Payment for goods and services can only be made by this method at premises having the
special machines for preparing sale vouchers to record the transaction, and retail outlets usually display the sings of
the credit cards they are prepared to accept.

It was in the fifties that many big banks in America adopted the credit card plan and it was in 1966 that Barclays Bank
was the first British bank to introduce credit cards known as “Barclaycard”. In the U.K., the credit cards are, however,
not restricted to banks, many retail chains and even small independent stores operate their credit cared schemes and
the phenomenal growth in their use indicates that “Plastic money” is gradually moving closer to a “cashless society.”

         To pay for goods, the cared is handed to the retailer, who places it in the special machine together with a sale
voucher, when the machine is operated, the embossed characters on the card, which detail the name and number of
the account, are recorded on the sales voucher together with the retailer’s name and address. The details and
amount of sales entered on the voucher and signed by the purchaser, after comparing this signature with that on the
card, and being satisfied with its authenticity, the retailer gives a copy of the voucher to the purchaser and hands back
the card. The retailer sends his part of the sales voucher to the using bank of the credit cared organization through a
local branch bank, and receives payment accordingly.

          Each month a cardholder is sent a statement depicting his purchases and he has the option of either paying
the full balance of the account or paying a certain minimum amount and carrying forward the remaining balance to the
next month. Cardholders are charged interest on outstanding balance and retailers are required to allow the bank a
rate of discount on all card sales-this varies from one trade to another, and averages between 2 and 3 percent. The
card can also be used to draw cash at bank branches and correspondent banks displaying the relevant credit card
          In India, credit cards are known as “Retail Credit Cards’ as a retail trader is fixed a limit in his credit card
account on the basis of his credit worthiness. The cards are to be used for he purchases made by the retailer from the
wholesaler or distributors to whom payment is made directly by the bank on the basis of invoices. On the same lines
one bank in India has introduced ‘Agricard’ scheme which enables the small farmer to purchase his requirement of
seeds, manure, pesticides, etc., from approved agencies. The invoices are sent to the bank with the Agricard for
payment to be made directly to the concerned dealer. Interest is charged to the Agricard holder from the date of

        The credit card system is advantageous to the traders who supply goods and services in that they are
assured of payment without having to send reminders for the outstanding debt. Further, bad debts are minimized and
more liquidity of current assets is assumed. Credit cards underwrite to a fixed amount and for a fixed period the credit
of a card holder.

Merchant Banking Services

         Merchant banking activity which was in its embryonic stage in India few years back and was, by a large,
confined to few larger banks has now become part and parcel of business of almost every bank. Merchant banking
Departments of banks offer a range of services to the business community and issuing house services are amongst
the most special offered by banks. There services include advising the clients as to the methods and terms of raising
capital organizing the actual issue and arranging for the underwriting. Methods of raising capital include: 1) the issue
by prospectus, where the issue is offered direct to the public on behalf of the borrowing company, ii) the offer for sale,
where the issuing house (merchant Banking Department of a Bank) buys the securities from the company and then
offers them to the public; and iii) placing the issue with a limited number of investors. The bank advises on the most
effective method of bringing the shares to the market and to gain Stock Exchange acceptability for them.

Apart from assisting new and existing companies in equity flotation, merchant banking activities include syndication of
loans, a techniques used when a group of banker, often from different countries, come together to provide large loans
on a joint basis. The bank that is organizing the loan called the lead bank, contracts other banks to participate.

        Management of capital issues is one of the main activities of a merchant banker operating in India, as stated
before. Very few of them have tried to develop other merchant banking services such as portfolio management,
project counseling, management consultancy, capital restructuring, corporate counseling and management of sick
units. Banks will have to develop the required skills and expertise in these types of activities to render efficient and
effective service to their customers. The banks may also assist the promoters to obtain technical data relating to
feasibility, market demand and other relevant aspects and would also work out the arrangements, for obtaining
finance from various institutions such a IDBI, IFCI and SFCs.

Providing Investment Advice

        Banks have wide knowledge of the financial market conditions because they invest their own surplus funds in
various securities and shares to comply with liquidity requirements and to earn a reasonable return on their
investment. But bankers do not normally take upon themselves the responsibility of giving specific advice to their
customers on investment. What they usually do is to either suggest he names of a few reliable stock and share
brokers without responsibility, from whom the customer may get the requisite advice or they themselves obtain the
advice from one or two reliable brokers and pass it on to the customer without responsibility.

        In this context, there is an important case of Woods V. Martin Bank Ltd. (1959) in which both the defendants-
the bank and the manager-were held liable for the loss of £14,800 caused to the plaintiff because the financial advice
had been given to the plaintiff without the ordinary care and skill that a bank manager should process. But this
decision should not terrify the banker if they act prudently and resist the temptation of introduction to the customer
who is seeking capital to another customer who has funds to spare, as happened in the Woods case.

         At least major commercial banks should make investment information available and publish a regular review,
containing up-to-date statistical information and comment on current economic conditions as well as articles of
interest to readers. Regular surveys of the economy as well as report on important overseas economies should also
be published for the enlightenment of bank customers and the sta Tax.

         This service is of recent origin and provides advice on income tax and other personal taxes such as capital
gains tax and capital transfer tax. The bank’s income tax department offers complete tax services which consist of
preparing the customer’s annual statement of income and expenditure, claiming allowances as permitted and
generally seeing that the customer pays no more tax than necessary, and claiming any rebate to which he may be
entitled. The Department can also provide a service to persons who are non-resident of India, but who have income in
this country.

        The tax departments are also to advise customers how to arrange their affairs to the best advantage of
themselves and their families. This involves a full consideration of the customer’s will, tax position, life insurance and
investment of capital so that a suitable scheme may be worked out to reduce taxation and meet his obligation and

        As a customer’s investment choices and tax position are closely interwoven, a bank, when providing tax
service, also often undertakes investment management for that customer. The banks accumulate massive expertise
in managing their own investment; selling this expertise to customers makes commercial sense.

Mobile Banking Facilities and Extension Counter Service

         The mobile banking or ‘Bank-on-wheel’ is a recent innovation in banking service to reach the rural areas as
part of performing the bankers social obligation. Mobile banks can be of much help in securing deposits from widely
scattered areas which would otherwise not be reached by normal banking facilities. Mobile banking requires a mobile
van which can safely travel on roads and is fitted with a counter and cash safe and is bullet proof, having a radio
telephone sysem./ The towns are generally fed daily and the villages bi-weekly or tri-weekly depending on the needs.
The bank is staffed with a manager, an accountant, one or two clerks and a driver who also acts as a guard. Despite
the problems of unsatisfactory communications and security in rural areas, this facility is worth developing both in the
context of social objectives and possibility of locating future centers for normal banking facilities.

         Extension counter service is also a recently innovated customer service. The extension counter is not a full-
fledged branch of a bank, but is only an extension of he deposit counter of the base branch, opened for the
convenience of those who find it difficulty to avail banking facilities during the usual banking hours. The facilities
provided by extension counter include: i) deposit transactions, ii) issue and encashment of drafts and mail transfers,
iii) encashment of travellers cheques, and iv) collection of bills. Like extension counter, morning and evening counter
are also opened for the convenience of the public.

Teller System

         One of the important measures for reducing the waiting time of customers at the counter is the adoption of the
teller system. It refers to the system under which the teller is authorized to receive cash and make payments up to
limited amounts without reference to the ledger balance or the specimen signature as he is expected to be thoroughly
conversant with the types of the accounts allotted to him and specimen signatures of the relative depositors. Only in
case of doubt the gets the balance or the signature verified by the ledger keeper and the supervisory official who are
seated near him. The teller system is adopted at certain selected branches and not all the branches of a bank.

         A variation of the teller system is the Prompt Payment System which involves maintenance of the record of
the customers’ account and their specimen signature in duplicate. On set, in the form of cards, is with the teller who is
authorized to pay cheque up to a specified amount out of the cash provided with him after verifying the signature and
positing the cheque in the ledger card.

        In either case, the object is to expedite payment of cheques for small amounts. Where the amount of the
cheque is in excess of the amount delegated to the teller, the cheque has to be dealt with by the ledger keeper in the
normal way and aid after all the usual formalities have been complied with through certain stages, i.e., clearance by
ledger keeper, passing officer and paying cashier.

Lock-Box and Night Safe Service

         Some banks provide the ‘Lock-box’ service at selected centers, which enables the customers, particularly the
traders, to lodge the cheques and other remittances in a box kept at the branch of a bank after office hours to be
collected by the bank the next day and necessary entries passed. It obviates the need for the customers to go to the
bank during the customer’s own office hours and thus saves time for them.

        Some banks also provide night safe facilities at selected branches whereby the customers, can lodge their
cash overnight. This service is particularly, useful for a trader who receives large sums of cash after the banks are
closed and who for security reasons does not wish to keep in on his own premises. The money is simply places in a
wallet and delivered through a chute accessible from the outside of the branch. A customer can either arrange for the
bank to open the wallet and credit his account, or he calls at the bank, opens the wallet himself and pays into his
account in the normal way.

The Clearing System

        The clearing system or simply ‘clearing’ is an arrangement through which a bank exchanges cheques drawn
on other banks for those drawn on it, thus eliminating the time-consuming and expensive method of presenting
cheques at the various banks at which they are drawn. This is done at the ‘Clearing House’ which is a Voluntary
association formed by a group of banks in a particular locality. The clearing principle is simple but the massive
number of cheques and drafts, etc., involved makes the process intricate.

Gift Cheques

       One of the new devices adopted by some banks to attract customers is the issue of gift cheques, artistically
designed in attractive folders and covers. The purchaser of a gift cheque need not be an account holder with that
bank or any other bank to avail of this service. The cheque is collectable at par at al offices of the issuing bank in

                                    BANKING – THEORY, LAW AND PRACTICE

                                             MODEL QUESTION PAPER
Time : 3 hours                                                   Max. Marks 100

                                         PART – A                      (5 x 8 = 40)
                                           (Answer any FIVE questions)

   1. Explain the constituents of balance sheet of a commercial bank.
   2. Explain the functions of central bank.
   3. Explain the defects of Indian Money Market. What are the steps taken by RBI to improve money market
   4. Discuss the special relationship between banker and customer.
   5. What is crossing? Explain the different types of crossing and their significance.
   6. What are the precautions to be taken by a banker while opening an account in the name of a Joint Stock
   7. What is passbook? Explain its relevance to a customer.
   8. What is cheque? What are its characteristics?

                                         PART – B                   (4 x 15 = 60)
                                           Answer any FOUR questions

   9.    Explain the functions of commercial bank.
   10.   “Loan Create Deposits” – Explain the statement and bring out clearly the process of credit creating by banks.
   11.   Define the distinguish “Branch Banking” and “Unit Banking”.
   12.   Explain the progress of banks after nationalization.
   13.   Explain the quantitative and qualitative methods of credit control.
   14.   Discuss the general relationship between banker and customer.
   15.   Who is a collecting banker? Explain the statutory protection given to him.



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