Lending by banks: principles, priority sector, securities, interest and penalty

1. Principles of good lending

• Safety. The bank lends depositors' money, so the first test is whether it will come back. The borrower's character, capacity and capital (the “three Cs”, often extended by collateral and conditions) are assessed.
• Liquidity. Deposits are largely repayable on demand, so advances should be repayable within reasonable time or readily saleable; long-term loans must be matched by long-term funds.
• Profitability. The rate must cover the cost of funds, risk and administration, within RBI directions on pricing.
• Purpose. The loan should be for a productive and lawful purpose, and its use should be monitored; diversion of funds is a ground for recall and, in serious cases, a fraud classification.
• Diversification. No excessive exposure to one borrower, group or sector; the RBI fixes exposure limits under s.21 of the Banking Regulation Act.
• Security. Security is a cushion, not a substitute for a sound borrower. The bank prefers security that is easy to value, store and sell, and free from encumbrance.
• National interest and social purpose. Lending must follow public policy: the priority sector, the prohibitions in s.20 (no loans against the bank's own shares or to its directors), and RBI's fair practices code for lenders.

2. Lending to the poor masses

Before 1969, bank credit went mostly to large industry and trade. Social control and nationalisation were meant to change that, and the tools are now settled:

• Priority sector lending. Under RBI directions, domestic commercial banks must lend 40 per cent of their adjusted net bank credit to the priority sector, with sub-targets for agriculture, small and marginal farmers, micro enterprises and weaker sections. The categories include agriculture, micro, small and medium enterprises, export credit, education, housing, social infrastructure, renewable energy and loans to weaker sections. Shortfalls must be deposited in funds such as the Rural Infrastructure Development Fund with NABARD. Banks may trade priority sector lending certificates. RRBs and small finance banks have higher targets.
• Lead Bank Scheme (1969): one bank in each district leads credit planning.
• Differential Rate of Interest scheme (1972): small loans to the poorest at a concessional rate.
• Regional Rural Banks (1975, Act of 1976) and NABARD (1982) for rural credit.
• Self-help group–bank linkage and microfinance; collateral-free loans to micro units under the credit guarantee scheme for micro and small enterprises.
• Financial inclusion: basic savings accounts, business correspondents, the Pradhan Mantri Jan-Dhan Yojana (2014), and direct benefit transfer.

3. Securities for advances: kinds, merits and demerits

• Pledge (ss.172–179 of the Indian Contract Act). Bailment of goods as security; the bank holds possession. Merits: possession, and the right to sell on reasonable notice (s.176). Demerits: storage and insurance costs, deterioration, borrower cannot use the goods. Used for gold loans and goods in godowns.
• Hypothecation. A charge on movables (stock, book debts, vehicles, machinery) without delivery of possession, defined in s.2(1)(n) of the SARFAESI Act. Merits: the borrower keeps using the asset. Demerits: risk of sale or double financing; the bank relies on stock statements and inspection. Registration with the Central Registry (CERSAI) and, for companies, with the Registrar of Companies protects priority.
• Mortgage (s.58 of the Transfer of Property Act). Transfer of an interest in specific immovable property as security. Banks use the English mortgage and, most often, the mortgage by deposit of title deeds (equitable mortgage, s.58(f)), which needs no registered deed. Merits: land does not perish, values tend to rise. Demerits: defects of title, costly enforcement, stamp duty and registration. SARFAESI now allows enforcement without court (s.13).
• Lien (s.171 of the Contract Act): the banker's general lien over securities in its possession, discussed in Unit III.
• Assignment of book debts, life insurance policies or other actionable claims (s.130 of the Transfer of Property Act; s.38 of the Insurance Act, 1938), with notice to the debtor or insurer.
• Guarantee (s.126 of the Contract Act). A personal promise by a third party. Merits: adds a second solvent person. Demerits: the surety may be discharged by variation, release of the principal debtor, or loss of security by the creditor (ss.133–141). A surety's liability is co-extensive with the debtor's (s.128), so the bank may proceed against him first: United Bank of India v. Satyawati Tondon, 2010 INSC 428, (2010) 8 SCC 110.
• Shares and securities (pledged in dematerialised form through the depository), fixed deposits (lien noted on the receipt), and documents of title to goods (bills of lading, warehouse receipts).

4. Precautions in lending against immovable property

• Title. Obtain a legal opinion on title, tracing it for at least thirty years through sale deeds, partition deeds, wills or grants; check that the mortgagor is the owner and has the power to mortgage.
• Encumbrances. An encumbrance certificate from the Sub-Registrar for the same period; a search of the CERSAI register under ss.20–26 of SARFAESI; for a company, the register of charges.
• Revenue and municipal records: mutation in the mortgagor's name, tax receipts, and for buildings, approved plans and occupancy certificates.
• Physical verification and valuation by an approved valuer; check possession, tenants and boundaries.
• Pending litigation: a property under a suit is subject to lis pendens (s.52 of the Transfer of Property Act).
• Co-owners and limited owners: consent of all co-owners; property of a minor needs court permission under s.8(2) of the Hindu Minority and Guardianship Act; coparcenary property binds only for legal necessity or benefit; restrictions on alienation of agricultural, tribal or granted land under State law.
• Documentation: original title deeds deposited at a notified town for an equitable mortgage, memorandum recording the deposit, proper stamp duty, registration where required, and insurance of buildings with the bank's interest noted.
• SARFAESI exclusion: a security interest in agricultural land cannot be enforced under SARFAESI (s.31(i)), so the bank must rely on suit or DRT.

5. Repayment, rate of interest and protection against penalty

• Rate of interest. Interest rates are deregulated, but loans must be priced against an external benchmark or other method the RBI prescribes, and the bank must disclose the rate and charges in a key fact statement. Section 21A of the Banking Regulation Act bars courts from reopening bank interest as excessive, and State moneylenders' laws do not apply.
• Compound interest at agreed rests is lawful; on a decree, the court awards interest under s.34 of the Code of Civil Procedure, as explained by the Constitution Bench in Central Bank of India v. Ravindra, 2001 INSC 520, (2002) 1 SCC 367.
• Protection against penalty. A stipulation for a higher rate on default is governed by s.74 of the Contract Act: the creditor may recover only reasonable compensation up to the stipulated amount. The RBI's fair lending directions on penal charges, applicable from 2024, require banks to levy penal charges (not penal interest added to the rate), reasonable and proportionate to the default, without capitalisation.
• Default. An account overdue for more than ninety days is classified as a non-performing asset. Recovery then proceeds by negotiation and compromise, civil suit, application to the DRT, SARFAESI measures, or insolvency proceedings, discussed in the next note.

How this is examined

“Discuss on general principles relating to secured loan” (January 2026), “Explain the good lending principles to be adopted by a banker” (August 2024), “What are the precautions to be taken by a banker while lending against immovable property?” (June 2025); short note “Priority sector advances” (January 2026, June 2025). For the secured-loan question, combine the principles with the kinds of security and their merits and demerits. For the priority sector note, give the 40 per cent target, the categories, the consequence of shortfall, and the object of directing credit to the poor.