CHAPTER FOUR

SECURED LOANS AND ADVANCES

4.1. MODES OF CREATING CHARGES:

The main principle of sound lending is to ensure safety of funds lent by the banker to his
customers. In this regard, the banker relies on the character, capacity, collateral, etc, of the
borrower in ensuring the safety of the funds. The viability of the project and the honesty and
capacity of the borrower ensure to a large extent the safety of funds lent by the banker. But the
bank can hardly afford to take any risk in this regard and hence reliance is placed on the tangible
assets owned by the borrower. In case of default by the borrower in repaying the loan, the
banker’s interests are safeguarded if he possesses a charge or right over a tangible asset of the
borrower. Loan with such right conferred upon the banker are called “Secured loans”. Thus,
secured advances are those, which provided absolute safety to the banker by the means of a
charge created on tangible assets of the borrower in favor of the banker. In such cases, the banker
gets certain rights in the tangible assets over which a charge is created. There are several modes
of creating a charge. They are as follow:

1. Lien 3. Hypothecation
2. Pledge 4. Mortgage

1. Lien:

Lien is the right to retain property belonging to another person until a debt due from the debtor is
paid. A lien is of two kinds: particular and general lien. In case of general lien, the bank has a
general right to the securities of the goods, which come into the possession of the bank in
ordinary course of banking business. The banker has no lien on safe custody deposits or on the
bills of exchange and other documents entrusted to the bank for special purpose. A particular lien
is the right to retain goods in respect of which the debt was incurred.

2. Pledge:

A delivery of goods, or documents title to goods, by a debtor to his creditor as a security for a
debt, or for any other obligation is called pledge. Here, the person who is pledging his goods or
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document of title to goods is the debtor and the person whose favor they are pledged is the
creditor. Thus, the debtor is known as pledger and the creditor is called pledgee. It is understood
that the subject of the pledge will be returned to the pledger when the debt has been paid or the
obligation is fulfilled. The legal ownership remains with the pledger (the debtor).

A pledge gives a right of sale if default is made in the payment of the debt within a reasonable
time. A pledge must be distinguished from lien. The pledges arises agreement and the lien by
implication.

3. Hypothecation and letter of Hypothecation:

In the case of hypothecation movable property is offered as a security for a debt. The borrower
continues to be the owner of the property and the property is not delivered to the lender. An
equitable charge is created in favor of the lender. In other words, the ownership of the property
rests with the borrower. Besides, the property will be in the possession of the borrower. Of
course, the borrower agrees to deliver the goods to the lender, whenever the lender asking for it.
Thus, hypothecation can be converted into a pledge by the lender at any time. In such, a case the
lender enjoys the powers and rights of pledge.

Letter of Hypothecation is an instrument or document of charge, which conveys to the bank the
full right to the property in the goods concerned. A letter of hypothecation is sometimes used to
describe a trust letter. Banks lend money against hypothecation of raw materials to the
manufacturers. This enables manufacturers to utilize the raw materials in the manufacture of
goods. This, in turn enables the borrower to make use of the terms and earn money. When, he
fails to pay the debtor or installments, the banker may ask the borrower deliver the raw materials
to him. An advance against stock in trades in possession of the borrower is risky. The borrower
may sell the goods hypothecated and may not deliver the hypothecated goods when he is
required to do so by the banker. Thus, the banker has to grant such loans to honest, reliable and
sound parties only. The banker must also make periodical inspection of goods hypothecated.

4. Mortgage:

When a customer offers immovable property like land and building as security for a loan, charge
thereon is created by means of mortgage.

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Mortgage is defined as “the transfer of an interest in specific immovable property for the purpose
of security and payment of money, advanced by way of loan, an existing or future debt, or the
performance of an engagement which may gives rise to a pecuniary liability.”

The transferor (borrower) is called “mortgagor”, the transferee (creditor) is called “mortgagee”,
the principle money and interest thereon, the payment of which is secured are called the
“mortgage money”, the instrument by which the transfer is effected is called a “mortgage deed”.

Characteristics of mortgage:

1. A mortgage is the transfer of an interest in the specific immovable property and differs
from sale wherein the ownership of the property is transferred. Transfer of interest in the
property means that the owner transfers some of the ownership rights to the mortgage and
retains the remaining rights with himself.
2. If there is more than one co-owner of an immovable property, every co-owner is entitled
to mortgage his share in the property.
3. The property intended to be mortgaged must be specific (that is, it can be described and
identified by its location, size, boundaries, etc,). A Mortgagor must mention which of his
properties is intended to be mortgaged.
4. The objective of transfer of interest in the property must be secure a loan or to ensure the
performance of an engagement, which results in monetary obligation. Thus, the property
may be mortgaged to provide security to the creditor in respect of the loan, which he
intends to take in the future. An existing overdraft can also be secured by the mortgage of
property. But, if a person transfers his property for a purpose other than the above, it will
not be called a mortgage, for example transfer of property in discharge of a debt is not a
mortgage.
5. The actual possession of the property need not always be transferred to the mortgagee.
6. The mortgagee gets subject to the conditions of the mortgage deed, the right to recover
the amount of the loan out of the sale proceeds of the mortgaged property.
7. The interest in the mortgaged property is returned to the mortgagor on the repayment of
the loan amount along with interest.

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 General principles of secured advances
The following are the principles to be observed by the banker while granting advances on the
basis of securities.

1. Adequacy of margins: the word “margin” has special meaning and significance in the
banking business. In banking terminology, “margin” means the difference between the
market value of the security and the amount of the advance granted against it. For
example, if the banker advances a loan of Br 20,000 against the security of goods with Br
40,000, the difference between the two Br20,000(40,000-20,000)is called margin.

A banker always keeps on adequate margin because of the following reasons:

i. The market value of the securities is liable to fluctuations in future with the result that
the banker’s fully secured loans may turn into partly secured loans.
ii. The liability of the borrower towards the banker increases gradually as interest and
other charges becomes payable by him. For example, if a loan of Br 2000 is
sanctioned by a banker today, the liability of the borrower at a future date, say a year
after, would be increased by the amount of interest accrued and other charges payable
by him. Hence the banker keeps adequate margin to cover not only the present debt
but also the additions to the debt.

Factors determining margin:

i. The amount of margin depends on upon the likely fluctuations in the prices of various
commodities. For example, if a commodity enjoys steady demand and an essential
item of consumption, lower margin is fixed. But if the prices of articles fluctuate
widely, then the banker should be careful in accepting such goods as securities and
thus margin should be high.
ii. In case of stocks of industrial concerns, the financial position and the reputation of
the issuing companies is also taken in to account. The stocks issued by sound and
well known industries are treated as good as government securities and a lower
margin is required.

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 iii.Margin are fixed keeping in view the credit and reputation of the borrower concerned,
that is, a lower margin may be fixed for the borrower having good reputation against
the security of the same commodity.
iv. The margin, determined at the time of sanctioning of a loan may be raised or reduced
subsequently according to the variations in the prices of the securities.
v. In case of commodities, which are subject to selective credit control of the central
bank margins are usually prescribed by the central bank of from time to time. It is
essential for the bank to keep such margin.
vi. Marketability of security: Advances are usually for short periods by the commercial
banks because their deposits resources (except term deposits) are either repayable on
demand or at short notice. If the customer defaults in making payment, the banker has
to liquidate the property. Therefore, it is essential that the security offered by a
borrower may be disposed of without loss of time and money. A banker should be
very cautious in accepting assets, which are not easily marketable.
2. Documentation: Documentation means that the necessary document such as, agreement
of pledge or mortgage, etc, are prepared and signed by the borrower at the time of
securing a loan from the bank. Though it is not necessary under the law to have such
agreement in writing and mere deposits of goods and securities will be sufficient to
constitute a charge over them, but it is highly desirable to get the documents contain all
the terms and conditions on which a loan is sanctioned by the banker and hence any
misunderstanding or dispute later on may easily avoided.

Advances (Loans) Against Different types of Security

 Advance against Goods:

Commercial banks make advances against goods of different varieties. The following are the
main items against which the loans are given;

 Agricultural products
 Industrial raw material
 Industrial products
 Food articles

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The main purpose of such advances is to meet the working capital needs of the business,
agriculture and industrial concerns. In fact, such advances are essential for all trading and
commercial activities in the country, which is, storing the agricultural output, the industrial raw
material and the finished products from the time of their harvest or production until their final
consumption.
Precautions to be taken by the banker while accepting goods as a security:
Goods and commodities are safe, sound and dependable securities for a banker but they are not
always free from certain risks. A banker should, therefore, be very careful in accepting them as
security and take the following precautions;

1) Though goods and commodities are the best securities to a banker for granting loans, the
customer is also equally important. The customer must be honest and trustworthy
otherwise the risks of fraud or dishonesty practice always remain. The banker depends
upon his past experience about the customer and also on the good will enjoyed by the
customer in the market. The customer must possess business talent and experience,
otherwise even an honest and reliable customer without competence and practical
experience is not free from risk.
2) Before accepting any commodity as a security the banker must be well acquainted with the
nature of its demand. He must enquire whether the commodity is an item of necessary or
luxury and whether its demand is elastic or otherwise, is constant throughout the year or
seasonal in nature. He should readily accept the commodities, which are necessaries of life
and are regularly consumed by large number of people because of their easy marketability
in case of need.
3) The banker should also confirm whether the commodity can be stored for a reasonable
period of time without deterioration in its quality, or value.
4) The banker must be well acquainted with the commodity market. He should know well the
commodities offered as a security, the conditions of their trade also the trend of their
prices in the market. Such knowledge is essential for him to regulate the margins to be
maintained.
5) The banker should take delivery of goods before he grants a loan against it to a customer.
Delivery may be actual delivery or constructive delivery. In case of constructive delivery,
the customer hands over the keys of the storehouse where the goods are being stored or
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 transfers the service of watchman. In some cases, the banker provides facilities usually
called “factor type” meaning thereby that the stocks pledged with the banker are permitted
to be processed or utilized by the debtor. The banker retains his charge over the same and
a nameplate of the banker is displayed at an important place in the business premises of
the debtor to indicate that the goods are pledged to the banker.
6) The banker should estimate the value of the goods very carefully. He should ensure the
exact quantity of goods pledged and find out their prices in the market through a broker, if
necessary. The invoice price given by the borrower should be checked because it may be
inflated one.
7) The banker should also take necessary care regarding the storage of goods pledged. The
storehouses should be safe from water, fire etc, and should be situated in good locality.
Proper record should be kept in the storehouse register.
8) The goods should be duly and adequately insured against fire, theft, etc. As the fire
insurance policies contain as “average clause”, the banker must get the goods insured for
their full value irrespective of the amount of the loan advanced because if the full value is
not insured the insurance company will pay the damages in the same proportion in which
the total value stands to the amount insured.
9) As the borrower is allowed by the banker to repay the loan in parts and get the
commodities released, it is very important for the banker to insure that goods released
should be in proportion to the amount of the loan repaid by the borrower. Hence, the
banker should strictly regulate the delivery of goods. All deliveries must be sanctioned by
the manager through the delivery orders specifying the quantum of goods and their
distinctive numbers.
 Advance against Documents of Title to Goods:

A document, which gives right to a person to take delivery or possession of goods, is called
documents of title to goods. That is the holder of the documents is entitled to the possession of
the goods stated in it. The following are the main documents of title to goods;

1) Bill of Lading:

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A bill of lading is a receipt for goods, upon shipment, signed by some authorized by the ship
owner. The document states that the goods have been shipped in good order, and quotes the rate
at which the freight is to be paid by the consignees. Here, the consignor the person who is
sending the goods (exporter) and the consignee is the person to whom the goods are being sent
(importer). A note is usually made upon the bill of lading that the weight, quantity and quality of
the cargo is unknown. The ship owner undertakes to deliver the goods at their port of destination
in the same condition as they also contain various terms and conditions under which the shipping
company agrees to transport the goods.
Bill of lading is usually drawn in three copies and in addition there are two copies. Of these two
copies, one is given to the master of the ship and the loading brokers retain the other. These
copies have no value and they are sometimes marked ‘copy not negotiable. One of the three bills
of lading is sent by the shipping to the consignee by one mail, and another is sent to him by
another route, if possible, or by the following mail, and the third is retained by the shipping
company as an evidence in support of a claim for insurance, in the event of ship being lost, that
the goods were in the ship. On the arrival of the ship in the port of destination, the consignee
may, by handing over the bill of lading to ship master and paying all claims for freight and other
charges, obtain the goods. If the consignee simply wants to transfer the goods to some other
person, he can, by endorsing the bill of lading and delivers it to that person. Thus, the person
getting the bill of lading endorsed in his favor will become the absolute owner of the
consignment.

2) Warehouse-Keeper Certificate or Receipt:

A document issued by a warehouse-keeper stating that certain goods is held in his warehouse at
the disposal of the person named. It is simply an acknowledgement of having received certain
goods. The receipt can be transferred by endorsement and delivery. The lawful holder is entitled
to receive the goods stated in it from the warehouse keeper.

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 3) Delivery order:

An order by the owner or holder of title to goods, addressed to a warehouse keeper, to the
superintendent of a dock or to a railway company, holding the goods, authorized and requesting
him to deliver the goods, whether in whole or part, to the bearer or the holder or to the party
thereon named by endorsement. When delivery orders are taken as security, the banker’s letter of
lien should be singed by the borrower and the bank should instruct the warehouse keeper to store
the goods in the bank’s name.

4) Railway Receipt:

It issued by a railway company. The railway company acknowledges the receipt of goods
described therein and undertakes to deliver the goods to the specific person at the place
mentioned in the documents.

Precautions to be taken by the banker while accepting documents of title to goods as a security:

A banker should take the following precautions while lending against the documents of title to
goods;

i) The banker should deal with honest, reliable and experienced customer. There is greater
scope for committing fraud in the case of documents of title to goods than in case of
goods. A dishonest person may prepare forged document. So, a banker should grant loans
only when the customer is strictly honest.
ii) The banker must receive certificate of packing. The documents contain the description of
goods only. Thus, it is necessary for the banker to know whether the packages contain the
goods described or not. So, he should ask for certificate of packing issued by a reliable
packer. Alternatively, he may depute a responsible person to be present at time of packing
the goods.
iii) The bill of lading is issued in a set of three. A banker should ask his customer to submit
both copies of the bill of lading before granting loan. Otherwise, the customer may present
one copy of the bill of lading and obtain the delivery of goods without the knowledge of
the banker.

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 iv)A banker must see that the goods are fully insured. He must ask the customer to submit
the insurance policy to him.
v) A banker should ask his borrower to endorse the bill of lading in blank. In such case, the
customer will be liable to pay freight if not it will be calculated as part of loan.
vi)When a banker wants to deliver the bill of lading or goods without receiving payment, he
must take a trust receipt from the borrower. The implication of this trust receipt is that the
borrower agrees to hold goods or sales proceeds in trust of the banker until entire amount
of loan is repaid. If the customer falls to pay the sale proceeds, he will be liable for
criminal breach of trust.
vii) The unpaid seller of goods has the right to stop the goods on their way to the buyer if the
buyer becomes insolvent before the goods are delivered to him. Therefore, the banker
should ask whether such an agreement exists between the buyer and the seller.
 Advance against Stock Exchange Securities:

We have different securities, which are traded in money market and capital market such as
shares, debentures, bill of exchange, bonds, Treasury bill, etc. Some of them are for short-term
securities traded in money market and others for long-term securities traded in the capital
market. These stock exchange securities are bought and sold in the stock exchange market.
Based on the past performance and on the future forecast, price of these securities fluctuate.
Borrowers sometimes offer these securities as pledged to secure loans from banks.

Precautions to be taken by the banker while accepting stock exchange securities:

a) A banker must study the working and progress of various companies whose shares are
purchased and sold on the stock exchange. For this, he must examine carefully the profit and
loss account and balance sheet of the companies for a number of years. He must also enquire
about the character and ability of directors or persons authorized to manage the company.
b) A banker should prefer preference shares and debentures to ordinary shares. The reason is
fluctuations in the prices of debentures and preference shares will be small. If he decides to
lend an ordinary share, he should lend against shares of first class companies. He should
avoid lending money against shares of new companies.

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 c) He should examine whether the shares are partly paid or fully paid. In the case of partly paid
shares, calls may be made by the company. A banker should take an undertaking from the
customer that would pay the call, if made. So he should make advances against fully paid
shares, and no advances as far as possible should be made against partly paid shares.
d) Most of stock exchange securities are not negotiable. So a banker must verify whether the
party offering securities for an advance has a good title to them or not.
e) The banker must also study carefully the price of securities. He must obtain official list of
prices of securities from the stock exchange authorities. When the prices of securities fall,
he must ask the customer to keep sufficient margin. This can be done by repaying part of the
loan or depositing additional security by the customer.
f) The banker must not accept securities in the name of a third party. The reason is he may be
holding them as a trustee. A banker should lend only when the securities are in name of the
borrower.
g) It is better that the securities are transferred to the banker and that the transfer is registered.
When the loan is repaid, the security may transfer to the customer. Alternatively, the banker
may secure equitable charge on the securities. He may ask the customer to deposit securities
within and take a blank transfer deed duly signed by the customer. In case of default of the
loan, the banker may fill in the transfer deed and get the securities registered in his name.
h) The banker should also immediately give a notice to the company stating that the securities
have been deposited with him and he has a charge on them. The notice will prevent of the
duplication of certificate.
 Advances against land and buildings:

Housing or building societies advances loans against houses. Land mortgages banks advances
loans against the mortgage of lands. But, commercial banks do not generally grant advances
against real estate loans like land and buildings (in case, in Ethiopia, as the financial institutions
of the country does not have any categories of different banks; commercial bank of Ethiopia
advances loans against buildings.) they generally try to avoid them as security for their advances
on account of many risks and disadvantages. Advance against property of this nature are not of a
liquid nature, because it is difficult to affect the sale of the property when the banker wants to
sell. Therefore the investment of banks in advances against property is usually very small.

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 Precautions to be taken by the banks while advancing against land and buildings:

1. It is very difficult to find out whether the person offering the security is the real owner of the
property or not. The reason is the law relating to succession and transfer of immovable
property is complicated. Only expert lawyers can state clearly whether a person has a good
title to the property or not.
2. It is difficult to value agricultural land and buildings. The reason is the valuation of this type
of property depends on various factors and situations. Therefore, only experts make proper
valuation.
3. Banks prefer to advance loans against securities that can easily marketed. But, land and
buildings cannot easily sold. They do not have regular market. One has to wait for months,
sometimes years to get proper price for the property. In times of financial stress and strain,
they are almost unsalable, in other words the security is frigid. Even when the property is
sold, there will be delay in the transfer of property to the buyer.
4. When a banker decides to advance money he must ask for a legal mortgage. The customer
has to incur heavy expenditure in making legal mortgage.
5. A person generally borrows money on the security of land or buildings for long periods and
thus lock up their funds, the reason is their deposits or liabilities are repayable on demand or
after a short period. Thus, the banker should ensure whether they maintain such deposits or
not. Because whenever demanded they may be in position to repay such a long term loan.
6. When a customer makes default, the banker has to sell the mortgaged property. He must
manage the property till it is sold. For example, in the case of a building he must suitable
tenants, collect and incurs expenditure on repairs. The bank the bankers will be put to great
trouble and inconvenience.
7. The banker should keep sufficient margin while making an advance. Margin should no less
than 50%. Good banker generally advance only one third of market value of the property.
8. There are difficulties in satisfying property against which the advance is required must be
free from all encumbrances. The banker has to satisfy himself by referring to the court
records whether the property is free from encumbrances or not.
9. As soon as the banker makes an advance against the property, he must get the insurance
effected.

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