Lending and Securities in Banking Law: Complete Notes

Lending is what a bank is for, and the law of lending is therefore the commercial heart of banking law. It has three layers. The first is prudential: why a bank lends as it does and how it decides. The second is proprietary: the four devices by which it takes security over property, and the contracts by which it takes the promise of a third person. The third is regulatory: the obligations the State imposes on where the credit must go. This note brings all three together.

1. The Principles and the Facilities

Figure 1: The layers a bank relies on, in order

• The canons: safety, because the money belongs to depositors; liquidity, because the bank's liabilities are repayable on demand; profitability, because the spread must cover cost, risk and capital; purpose, because the purpose indicates the source of repayment; diversification; security, as a cushion and not a substitute; and national interest.
• Appraisal: character, capacity, capital, collateral and conditions, supported by credit information under the Credit Information Companies (Regulation) Act, 2005, an internal rating, and pricing linked to an external benchmark since 1 October 2019.
• Fund based facilities: term loan, cash credit, overdraft and bill finance. Money leaves the bank, the income is interest, and the exposure is an asset.
• Non-fund based facilities: letter of credit and bank guarantee. Nothing moves until invocation, the income is commission, and the exposure is a contingent liability converted for capital by a credit conversion factor.
• Working capital: the Tandon (1975) norms, the Chore (1979) discipline and the Nayak (1991) turnover method, which takes the need at 25 per cent of projected turnover, survive as practice rather than regulation, with a loan component required for large borrowers and drawing power controlled by stock statements.
• Lending together: consortium lending shares one appraisal and a pari passu security; multiple banking shares nothing, which is why information sharing and central registry filing matter.

2. The Four Modes of Charge

Figure 2: Possession and the kind of property decide the mode

• Lien: Section 170 gives a particular lien for services involving labour or skill; Section 171 gives bankers a general lien over goods bailed to them, securing the general balance of account, treated as an implied pledge so that the bank may sell after notice. A negative lien is not a lien but an undertaking not to encumber.
• Pledge (Section 172): the bailment of goods as security, requiring delivery, actual or constructive. The pawnee has a special property; the pawnor keeps the general property. Section 173 permits retention for debt, interest and necessary expenses; Section 174 bars retention for other debts absent a contract; Section 176 allows the pawnee to sue and retain or to sell on reasonable notice; Section 177 preserves redemption until the actual sale. Sections 178, 178A and 179 validate a pledge by a mercantile agent, by one holding under a voidable contract, and by one with a limited interest.
• Hypothecation: a charge on movable property, existing or future, without delivery of possession, defined in Section 2(1)(n) of the SARFAESI Act, 2002 and including a floating charge and its crystallisation. It rests on the deed, whose key covenant is the right to take possession on demand.
• Mortgage (Section 58(a), Transfer of Property Act, 1882): the transfer of an interest in specific immovable property to secure a debt. Section 59 requires a registered instrument attested by two witnesses where the principal is ₹100 or more, except for a mortgage by deposit of title deeds. The six kinds are simple, conditional sale, usufructuary, English, deposit of title deeds and anomalous. Section 60 preserves redemption, and a clog on it is void.
• Registration: a company's charge under Section 77 of the Companies Act, 2013 within thirty days, failing which it is ignored in liquidation; every security interest with CERSAI under Section 26B of the SARFAESI Act, which fixes priority.

3. Guarantee and Indemnity

Figure 3: Property security and personal security compared

• Indemnity (Sections 124 and 125): a two party, primary promise to save another from loss.
• Guarantee (Section 126): a three party, secondary promise to perform the promise or discharge the liability of a third person in case of his default. It may be oral or written, and Section 127 makes anything done for the benefit of the principal debtor sufficient consideration.
• Section 128: the surety's liability is co-extensive with that of the principal debtor unless otherwise provided by the contract, so the creditor need not sue the borrower first or realise his security before calling on the guarantor.
• Continuing guarantees: Section 129 defines them; Section 130 allows revocation by notice and Section 131 by the surety's death, in each case as to future transactions, after which the bank must break the account to defeat Clayton's case.
• Discharge: variance (133), release of the principal debtor (134), composition, time or a promise not to sue (135), an act or omission impairing the surety's remedy (139), and loss of a security to its value (141). Mere forbearance does not discharge (137). Most of these are waived in a bank's standard form.
• The surety's rights: subrogation (140), the benefit of the creditor's securities (141), an implied indemnity from the principal debtor (145), and equal contribution between co-sureties (146 and 147).
• In insolvency: the moratorium under Section 14 of the Insolvency and Bankruptcy Code, 2016 does not protect a personal guarantor, and approval of a resolution plan does not automatically discharge him, because his liability rests on a separate contract.

4. Documentary Credits and Bank Guarantees

• The letter of credit: a bank's undertaking to pay a beneficiary against specified documents, governed by UCP 600, which binds as incorporated contract and not as law. Under UCP 600 a credit is irrevocable unless it says otherwise.
• Autonomy: the credit is a transaction separate from the underlying contract, and banks deal in documents and not in goods. Without that independence the credit would be worth no more than the buyer's own promise.
• Strict compliance: documents are examined on their face to see whether they appear to constitute a complying presentation, within five banking days, with data that must not conflict. A refusal must be by a single notice stating every discrepancy, or the bank is precluded.
• The bank guarantee: an undertaking to pay on the beneficiary's demand. An on demand guarantee is autonomous, so the Contract Act defences of a surety do not apply.
• Restraining encashment: only for egregious fraud going to the root of the transaction, pleaded with particulars and of which the bank has notice, or for irretrievable injustice or special equities. A non-conforming invocation is a separate and narrower ground.

5. Priority Sector Lending

• The power: Sections 21 and 35A of the Banking Regulation Act, 1949, exercised through the Reserve Bank Directions of 2025, effective 1 April 2025, with earlier qualifying loans eligible until maturity.
• The categories: agriculture; micro, small and medium enterprises; export credit; education; housing; social infrastructure; renewable energy; and others, with weaker sections cutting across them as a category of borrower.
• Commercial banks and foreign banks with twenty or more branches: 40 per cent of adjusted net bank credit or the credit equivalent of off balance sheet exposure, whichever is higher; 18 agriculture, of which 14 for non-corporate farmers and 10 for small and marginal farmers; 7.5 micro enterprises; 12 weaker sections.
• Others: regional rural banks at 75 per cent, with weaker sections at 15; urban cooperative banks at 60 per cent under the 2025 Directions, and small finance banks at 60 per cent from 2025-26, both reduced from 75.
• District weights: from 2024-25, incremental priority sector credit carries 125 per cent where per capita priority sector credit is below ₹9,000 and 90 per cent above ₹42,000, with regional rural, urban cooperative, local area and foreign banks exempt.
• Shortfall: deposited with NABARD, SIDBI, NHB or MUDRA at a return below the market rate. Priority sector lending certificates, from 2016, allow the achievement to be traded while the credit risk stays with the originator.
• Delivery: the lead bank scheme of 1969, the annual credit plan, the self help group bank linkage and business correspondents.

6. How Lending Law Holds Together

The structure runs from the least to the most coercive. A bank lends first against the borrower's cash flow, which is what appraisal tests and what the canons are directed at. It takes security over property to limit the loss if the cash flow fails, choosing the mode by two questions only: whether the property is movable and whether the bank can take possession. It takes a guarantee because it costs nothing and reaches assets it could never charge, at the price of a long list of ways the surety may escape. It takes non-fund based exposure where the customer needs a promise rather than money. And behind all of it sit the recovery statutes, which are what the whole structure is designed to avoid having to use.

The regulatory layer cuts across all of this. Section 20 forbids lending to directors and their interests; Section 21 lets the Reserve Bank fix the purposes, margins, ceilings and rates of lending, which is where priority sector obligations come from; and Section 21A stops a court reopening the rate. A lending decision in India is therefore never purely commercial, and any answer on the subject must account for both the private law of the security and the public law of the direction.

7. Quick Revision

8. Frequently Asked Questions

What is the difference between pledge, hypothecation and mortgage?

A pledge is a bailment of movables with delivery of possession to the bank (Section 172). A hypothecation is a charge on movables without delivery, so the borrower keeps and uses them (Section 2(1)(n), SARFAESI Act). A mortgage is the transfer of an interest in immovable property to secure a debt (Section 58, Transfer of Property Act, 1882). The mode turns on two questions: is the property movable, and does the bank take possession.

Can a bank sue the guarantor without suing the borrower?

Yes. Section 128 makes the surety's liability co-extensive with that of the principal debtor, and it arises on his default, not on the exhaustion of remedies against him. The creditor need not first sue the borrower or realise his security, and a decree may be executed against the guarantor alone, unless the contract provides otherwise.

When will a court stop the encashment of a bank guarantee?

Only for egregious fraud going to the root of the transaction, pleaded with particulars and of which the bank has notice, or for irretrievable injustice or special equities going beyond ordinary financial prejudice. U.P. Cooperative Federation Ltd. v. Singh Consultants and Engineers (P) Ltd., (1988) 1 SCC 174 held that a bank's commitment must be honoured free from interference by the courts, and that a dispute or pending arbitration is no ground.

What happens if a company's charge is not registered?

It is not taken into account by the liquidator or any creditor in a winding up or insolvency, so the bank is reduced to an unsecured creditor. Section 77 of the Companies Act, 2013 requires registration within thirty days of creation, and permits the charge-holder to register, which is why a bank files itself rather than relying on the borrower.

What is the priority sector lending target and what happens on shortfall?

Forty per cent of adjusted net bank credit or off balance sheet exposure, whichever is higher, for commercial banks, with sub-targets of 18 agriculture, 10 small and marginal farmers, 7.5 micro enterprises and 12 weaker sections. A shortfall must be deposited with NABARD, SIDBI, NHB or MUDRA at a return below the market rate, and priority sector lending certificates allow the achievement, but not the credit risk, to be bought from a bank with a surplus.

Why is a guarantee said to be the cheapest and most fragile security?

Cheapest because it costs almost nothing to create, needs no registration, and reaches assets the bank could never have charged. Most fragile because the Contract Act discharges the surety for a long list of reasons, including variance, release of the debtor, giving time, an act impairing his remedy and the loss of a security, most of which a careless lender may do without noticing. Bank forms therefore take the surety's advance consent to all of them.

In what order should a lending and securities question be answered?

In four steps. First, is the advance within the bank's power, which engages Section 20 on lending to directors and Section 21 on the policy in relation to advances. Second, has the security been validly created, which turns on delivery for a pledge, on the deed for a hypothecation and on Sections 58 and 59 for a mortgage. Third, has it been registered where registration is required, under Section 77 of the Companies Act or with CERSAI. Fourth, is it enforceable, which asks whether notice has been given, whether the guarantor has been discharged, and whether the bank may proceed under the SARFAESI Act or must sue.

What is the single most common reason a bank loses its security?

Failure at the moment of creation or registration, not at enforcement. A mortgage not properly attested, a memorandum drafted so as to create rather than record a deposit of title deeds, a company charge not filed within thirty days, a hypothecation not entered at CERSAI, or a guarantee taken without fresh consideration, each leaves the bank holding a document that will not do the work it was taken for. The enforcement statutes cannot cure a defect in the charge itself, which is why documentation is treated as the most important stage of the credit cycle.

Which security should a bank take, and why does the choice matter?

The choice is governed by what the borrower can give up and by how the bank will enforce. A pledge gives the bank possession, which makes enforcement simplest, since the pledgee may sell after reasonable notice without any court, but it is useless where the borrower needs the goods to trade. Hypothecation leaves possession with the borrower and is therefore the practical security over stock in trade and receivables, at the price that the bank holds only a charge and must obtain possession before it can sell, which the securitisation statute now permits it to do without a court. A mortgage of immovable property is the strongest security in value and the slowest to realise, and the equitable mortgage by deposit of title deeds is preferred because it needs no registered instrument and is quick and cheap to create. A guarantee adds a person rather than an asset, and is worth only what the guarantor is worth when the default occurs.

9. Related Topics and Provisions

• Non-performing assets and provisioning norms
• Wilful defaulters and the fraud classification framework
• The SARFAESI Act and enforcement of security interest
• Recovery of Debts and Bankruptcy Act, 1993
• The Insolvency and Bankruptcy Code, 2016 and banks
• Restrictions on loans and advances (Sections 20 and 21)
• Instruments of monetary control