NATURE OF SECURITIES AND RISKS INVOLVED

This article is written by Sowjanya. N of 6th Semester of BA.LLB (Hons.) of University Law College and Department of Studies in Law Bangalore University, an intern under Legal Vidhiya

Abstract

Loans play a crucial role in modern economies and personal financial planning, serving as essential financial instruments that fulfil various needs and facilitate growth. They are bridges connecting aspirations to accomplishments, innovations to industries, and individuals to opportunities. While loans offer numerous advantages, it’s essential to recognize that responsible borrowing and thoughtful consideration of repayment capabilities are crucial. loan expose banks to the risk of loan defaults, impacting profitability, capital adequacy, and overall financial stability. To mitigate these risks, banks employ careful risk management practices. The need for securities in loans is one of the fundamental principles of risk management, lender protection, and maintaining the stability of the lending ecosystem. securities in loans create a balanced relationship between borrowers and lenders. They provide lenders with a layer of protection while giving borrowers the opportunity to access funds for their needs. This article discusses the fundamental principles of loans, the necessary qualities of good securities, the various types of securities, and the benefits and drawbacks associated with each.

Keywords: General principles of loan, requisites of good securities, kinds of securities, advantages of securities, disadvantages of securities, securities in banking law, types of loan, risk involved in securities, nature of securities.

Introduction

In banking law, the term “securities” refers to financial instruments that can be bought, sold, or traded in financial markets. These instruments represent ownership interests, debt obligations, or other rights and are often used as collateral for loans and other financial transactions. Securities can take various forms, such as stocks, bonds, derivatives, and other financial instruments. Securities play a significant role in the banking and financial industry, and banking law regulates various aspects of their issuance, trading, and use as collateral.

Loan

Typically, the term “loan” refers to lending or something that is lent. Any advance with interest, whether it be in cash or in kind and with or without security, is referred to as a “loan.” A loan is a financial transaction in which one party, typically a lender such as a bank or a financial institution, provides a specific amount of money to another party, known as the borrower. The borrower agrees to repay the borrowed amount along with an agreed-upon interest or fee over a defined period of time. Loans are a fundamental aspect of the financial system and are used by individuals, businesses, and governments to access funds for various purposes.

One of the most significant tasks carried out by commercial banks is lending, which also serves as a significant source of income for the bank. Banks that deal with public funds accept deposits and lend to their borrowers in order to generate a profit. To ensure the safety, security, and profitability of the money they lend, banks adhere to a few basic lending principles.

General principles followed by banks while lending loans are as follows :

• Principle of Safety:

The most important guiding principle of lending is safety. The bank lends the money that depositors have entrusted to it, hence the first and fundamental rule of lending is to assure the security of the money lent. Safety refers to the borrower’s ability to return the loan in full, including interest, in accordance with the conditions of the loan contract. The repayment of the loan depends upon two factors (a) the borrower’s capacity to pay, and (2) the borrower’s willingness to pay. The former depends on the repayment capabilities and financial health of the borrower latter depends on the character of the borrower he should be a person of integrity, good character, and reputation.

The safety of funds also depends on the nature of security if the borrower fails to pay the loan it will be recovered out of the sale proceeds of security. The security offered need to be adequate to pay the loan’s costs. The banker generally relies on the security of tangible assets owned by the borrower to ensure the safety of his funds.

• Principle of Liquidity

Banks lend public money which is repayable on demand by depositors so the bank lends for a short period. The bank loans are largely payable on demand. The banker is responsible for making sure the borrower can pay back the loan quickly or on demand. This is dependent on the nature of assets that the borrower owns and pledges to the banking.

. For instance, while fixed assets like land, buildings, and specific kinds of plants and equipment cannot be liquidated immediately, goods and commodities can. Liquidity is just as crucial to the banker as the safety of the funds, and loans are only given in exchange for easily tradable assets that can be sold for a profit.

• Principle of Purpose

Before lending banker enquires from the borrower about the purpose for which he seeks the loan. The purpose of a loan helps in determining the level of risk and also impacts the interest rate on a loan. To ensure the safety and liquidity of funds banks grant loans only for productive purposes for meeting the working capital needs of a business enterprise. Loans are not advanced for speculative and unproductive purposes. Thus, the Purpose of the loan should be productive in order to ensure the safety of funds while it should be extended for the short term to ensure liquidity.

• Principle of risk diversification  

This is a cardinal principle of sound lending. Every loan has its own risk. The banker follows the principle of diversification of risks based on the famous maxim “Do not keep all the eggs in one basket.” This means that the banker shouldn’t restrict the advances to just a few large companies, certain sectors of the economy, or particular towns or geographical areas. On the other hand, the advances should be spread over a reasonably wide area, distributed amongst a good number of customers belonging to different trades and industries. The banker, thus, diversifies the risk involved in lending. Lending surplus to a particular sector may have an adverse effect on banks in times of recession. So, even if the recession negatively impacts some industries or trades, the bank’s overall position will not be jeopardised.

• Principle of Profitability

Commercial banks are institutions that generate profits. They must make profitable use of their capital in order to generate enough revenue to cover all necessary operating costs, including paying employee wages, depositor interest, and shareholder dividends. The bank’s gross profit is determined by the difference between borrowing and lending rates. The variations in the rates of interest charged to different customers depending upon the degree of risk involved in lending to them. So, a banker must extend the advance in such a way that it is profitable for the bank and also at a competitive lending rate. The fundamental principle of lending prioritizes maintaining safety and liquidity over pursuing greater profitability thus, banks should not ignore the safety or liquidity.

• Principle of Security

Anything that is provided as collateral for a loan or advance is referred to as security. A banker will not lend to an unsecured borrower. In the event of a default by the borrower, security serves as insurance for the lender bank. A wide range of securities, including gold, silver, and property, may be offered in exchange for loans. The security that a banker accepts as a loan cover must be sufficiently manageable and easily marketable.

Types of loan

Loans can be divided into various types based on the purpose and the term of repayment. Based on the security or collateral, loans can be classified as either unsecured or secured loans.

• Unsecured loan

Unsecured loans are any loans that are not supported by assets or collateral. In other words, the borrower is not required to put up any valuables as collateral for the loan. Instead, the borrower’s creditworthiness, income, and financial history are taken into account when the lender decides whether to authorise the loan.

Unsecured loans often have higher interest rates than secured loans because there is no collateral present to lessen the risk to the lender. Personal loans, credit card debt, and certain student loan programs are typical examples of unsecured loans.

• Secured loan

A secured loan is a type of loan that is backed by collateral or assets provided by the borrower. For the lender, collateral acts as a type of security, lowering their risk in the event that the borrower defaults on the loan. If the borrower fails to repay the loan as agreed, the lender has the right to take possession of the collateral to recover the loan amount.

Secured loans typically come with lower interest rates compared to unsecured loans because the presence of collateral reduces the lender’s risk. Mortgage Loans, Auto Loans, Home Equity loans, Secured Personal Loan, and Secured Business Loan are some examples of secured loans.

Securities

In banking law, “securities” in the context of a secured loan typically refer to financial assets that are pledged as collateral to secure the loan. These securities provide the lender with a form of assurance that, in the event the borrower defaults on the loan, the lender can take possession of the pledged securities and sell them to recover the outstanding loan amount.

ATTRIBUTES OF GOOD SECURITY ARE AS FOLLOWS:

1. Title of the security:

Clear and well-documented ownership is a requirement for good security. A borrower should have a clear title to the security, and the title should be undisputed. The borrower should prove with evidence that he has complete ownership of the security and that he is authorised to use it as security.

1. Non-encumbrance:

The security should be free from liabilities or encumbrance. There shouldn’t be any disputes, liens, or third-party claims involving the collateral. To prevent difficulties during enforcement, the collateral must have a clear legal title.

1. Marketability:

The collateral should be marketable and easily convertible into cash through a sale. Marketable collateral ensures that the lender can quickly recover the outstanding loan amount by selling the collateral in the event of default.

1. Value:

 It is considered to be good security if the cost of the security can be easily ascertained. Good security should have sufficient value to cover the loan amount and potential interest in case of default.

• Stability of value:

Collateral with stable value is preferable. The security should not be liable to wide price fluctuation. The value of security needs to be reasonably constant. Bankers must also ensure that the security’s value does not fluctuate drastically over a short period. While market swings can affect the value of any asset, less variable collateral offers the lender greater predictability.

• Storability:

The security should be easy to store. Security should be such that they satisfy the requirement of easy storage and do not require special storage facilities.  Goods should not be risky to store, such as inflammable articles. Goods which require a special storage facility are not preferable as it infers additional expenses to the banker.

• Transferability:

The transfer of security should be simple and unrestricted. It is preferable to have collateral that can be quickly transferred into the lender’s ownership in the event of default. This characteristic enables the lender to realise the value of the collateral without facing any legal issues.

• Durability:

Security should be reasonably durable. Vegetables, fruits, and other perishable commodities that require extra efforts to keep in the same condition are also not preferred and are not good security. The goods which are durable like metal, jewellery is preferred.

1. Transportable:

Transporting security should be easy and simple. Security should be able to be shifted from one location to another with no difficulty. Securities which are easily transportable at less cost are preferable over those that are difficult and expensive to transport. They can be shifted from one market to another for easy disposal.

• Convertible Assets:

 Assets that can be easily converted to cash, such as marketable securities, are preferred as collateral due to their liquidity.

• Maintainability:

Collateral that is relatively easy to maintain, such as real estate or financial assets, is preferable. Maintaining the collateral ensures that its value is preserved until the loan is repaid.

Kinds of securities

1. Land/Real Estate

Real property such as land, homes, commercial buildings, or other real estate assets can serve as collateral for secured loans. Mortgages are a common example of secured loans where the property being financed serves as collateral. In the past, banks were very hesitant to accept land and buildings as security; but, over time, this prejudice has changed, and land and buildings as security have become an accepted collateral in most advances. It is currently a standard form of security that banks accept. The advantages and disadvantages of this form of security cannot be universally applied to all lands and it depends on the nature of the land offered.

Advantages:

1. The value of land increases over a period of time.
2. Under the SARFAESI Act of 2002, the mortgaged property may be securitized without court intervention

Disadvantages:

1. Difficulty in valuation: Real estate valuation can be challenging at times because it depends on a number of variables, including location, property condition, size, and more.
2. Ascertaining the title of the owner is time-consuming: The borrower must be the owner of the property being mortgaged in order for the banker to obtain a legal title. In India, where the law of inheritance is governed by the personal laws of different religions, determining whether the borrower has a legitimate title or not takes time.
3. Not readily realisable: Due to the absence of a ready market, the land is not easily and speedily realisable. It can take months to sell, and if the market is unfavourable, it might sell for less money than was planned.
4. Creating a charge is costly: The security may be pledged as collateral either through a legal mortgage or through an equitable mortgage. Since a legal mortgage’s remedies prevail over an equitable mortgage’s, the former is preferable. However, there are costs associated with completing a legal mortgage, such as stamp duty, as well as several formalities which make it a costly affair.
5. Stocks and Shares :

These can be divided into equity shares and preference shares.  Preference shares are those which enjoy preference both with regard to the payment of dividends and the repayment of capital on the other hand equity shares that are not preference shares.

Advantages

1.  Ascertaining the value of stocks and shares is easy.
2.  Stocks and shares typically have stable values and are not prone to significant fluctuations.
3. The formalities for using stocks and shares as collateral are quite minimal.
4. Ascertaining the title of a share is easier compared to that of real estate.
5. Creating a charge of this is less expensive than real estate.  Compared to real estate, the cost of creating a charge is less.
6. They generate money in the form of dividends that can be applied to the loan account.
7.  They are more trustworthy as they are tangible securities.
8.  Such securities are released with relatively little expenditure and formality.

Disadvantages:-

1. They must be appropriately guarded because they are easy to realise and thus prone to fraud.
2. Partly paid shares have the following demerits:
   1. The calls may need to be paid by the banker.
   1. Prices for partially paid shares change drastically.
   1. Due to the limited market for such shares, they are not readily realisable.
3. Debentures

Debentures are a type of long-term debt instrument issued by corporations, governments, and other entities to raise capital. They are essentially loans taken out by these entities from investors, who purchase the debentures with the understanding that they will receive interest payments and the principal amount back at maturity.

Advantages

1. Selling of debenture is easy.
2. Price of the debentures is not subject to violent fluctuations.
3. Cost of transfer is very less.
4. Bearer debentures are completely negotiable.
5. They are given priority over shares and are often backed by a charge against the company’s assets.

            Disadvantages

1. The debentures’ marketability and pricing would be affected if interest wasn’t paid on a regular basis.
2. If a charge against a company’s property is not registered, the subsequent charges will take precedence.
3. Companies that lack the ability to borrow money may issue debentures.
4. Goods :

Using goods as security for a loan involves pledging tangible assets owned by a borrower as collateral to secure the loan. Goods can include physical products, inventory, equipment, and other movable assets that have value.

Advantages

1. Unlike other forms of security, goods can be quickly traded since there is a ready market for them.
2. It is simple to determine the value of goods.
3.  Since advances on products are typically granted for short periods of time, the banker’s risk is significantly minimised.
4. Creating a charge against the security is generally less expensive and requires fewer formalities, with the exception of a few states where the stamp fee is high.
5. When a banker does business with reputable and established clients, they obtain a good title to the items.

           Disadvantages

1. The value of the banker’s security may be diminished over time as a result of certain items’ propensity to expire or deteriorate in quality.
2.  There could be a chance that the borrower will commit fraud or act dishonestly.
3.   The value of certain collateral, especially electronic consumer goods, can change significantly, making their valuation challenging. Even for essential items with multiple variations, unless the banker is an expert, valuation can be misleading. Selling large quantities quickly might be tough and might not yield the anticipated price.
4. It might be difficult for the banker to store the goods.
5.  Transporting goods from one place to another is costly and time-consuming.
6. In cases where goods are stored in a warehouse, the warehouse keeper holds a lien on the goods for any outstanding charges. Consequently, the banker needs to regularly confirm that all fees are appropriately settled.
7. Life Policies

Using life insurance policies as security for a loan involves pledging the policy’s cash value or death benefit to secure a loan. The policy serves as tangible security and is held by the bank. If the borrower defaults on payment, the security can be promptly converted into cash by surrendering the policy to the insurance company.

Advantages

1. Realisation of policy is easy.
2. There are very few formalities involved in assigning the policy in the banker’s benefit, and the banker is given a perfect title.
3.  The surrender value increases with the length of time the policy have been in effect.
4.  If the borrower doesn’t make their payments as agreed, the security can be realised right away by surrendering the policy to the insurance provider.
5. The policy acts as concrete collateral and is under the control of the bank. The banker’s responsibility primarily involves ensuring the consistent payment of premiums.
6. Disadvantages
7. If the premium is not paid regularly, the policy lapses, and reviving the policy is complicated.
8. All the requirements of valid assignment should be fulfilled without which the banker cannot acquire complete benefit of the policy. If the policy contains any clause against the assignment need to be taken into notice.
9.  The policy deposited should be a valid insurance contract and should have fulfilled all the requirements of a valid insurance contract. Failing to fulfil any of the requirements of the insurance will render the policy void.
10.  The policy may contain special clauses, which may restrict the liability of the insurer.
11. Special precautions need to be taken while accepting policy under Married Women Property Act.
12. Banker should always make sure that the policy deposited is original and there are no encumbrances on the policy.
13. Fixed Deposit

A Fixed Deposit (FD), also known as a Term Deposit or Time Deposit, is a financial arrangement where an individual deposits a specific sum of money with a bank or financial institution for a predetermined period at a fixed interest rate. A person receives the initial deposit amount plus any accumulated interest at the maturity date.

 Banks commonly allow depositors to use their deposits as collateral for borrowing. This collateral is highly valuable, as the deposited funds are already held by the bank. This eliminates concerns related to assessing value, verifying ownership, or managing storage and associated expenses.

Conclusion

 In conclusion, the nature of securities and associated risks highlights the delicate balance between borrower protection and lender security. The use of tangible and financial assets as collateral provides a safety net for lenders, offering assurance against potential default. However, risks such as asset depreciation, value assessment challenges, legal complexities, and borrowers’ financial circumstances underscore the need for meticulous due diligence on both sides. Striking the right balance between providing credit to borrowers and safeguarding lenders’ interests requires careful consideration of regulatory compliance, transparent communication, and a thorough understanding of the terms and obligations.

References

• BANKING LAW AND PRACTICE, The institute of company secretariat of India, Module 3, elective paper 9.
• https://bankingdigests.com/blog/types-of-securities-and-their-characteristics-in-banks/