Banks do business with depositors’ funds. The Banks have to honor their commitment to return the deposits whenever demanded by the depositors. The primary source of funds for repayment is the business itself; hence banks take considerable care to evaluate the profitability and sustainability of the business financed by them. Despite all care and due diligence some of the businesses could fail. The cause of failure may be changes in the external environment or mismanagement. Banks have to ensure that even if the business fails, their funds are recoverable by invoking the “Security” offered by the borrowers. Security is an asset like land, building and machinery, stocks (raw materials / finished goods), receivables and other securities which are charged to the bank. Charge is the legal right given by the borrower to the bank to take possession of dispose of the security in the event of default. The types of charges are:
Pledge is a charge where the borrower hands over possession of asset to the bank. For example loans against gold jewellery, warehouse receipts, key loan etc. The relationship between borrower and the bank is “Pledger” and “Pledgee”. Under this, the ownership of the goods remains with the borrower but the possession of the goods is in the hands of the bank. The bank enjoys Right of Sale in case the loan is not repaid and the bank can sell the pledged goods after giving adequate notice of sale to the borrower. It is the responsibility of the bank to take as much care of the goods pledged as a man of ordinary prudence would under similar circumstances. When the loan is fully paid, it is the responsibility of the bank to handover the possession of the goods back to the borrower.
Hypothecation – Normally banks lend funds to the borrowers to acquire raw material / assets to undertake their business activities and these assets continues to be in the possession of the borrower. It is as if the borrower holds the asset on behalf of the Bank. Hypothecation gives the Bank right to take possession and sell the asset, in case of default. However, bank need to initiate action either under SARFEASI or Court/DRT to take possession of the asset.