MBA Banking Law and Practice

Banking law & Practice Assignment

Q.1 How does the State Bank of Pakistan control the banking system of the country?

Ans. In the following salient features of the State Bank of Pakistan to control the
banking system are discussed which are mainly instruments used in Pakistan since all
the conventional control techniques are not applicable in developing countries:

• Bank rate

This is the rate at which the State Bank buys or discounts bills of exchange and
other commercial papers. This is also the basic interest rate. All the other interest
rates in the banking system, like the deposit rate paid by the banks to their
depositors and the rates at which bank lend for short and long periods, are tied to
it. With any change in the bank rate, similar changes take place in the entire
interest rate structure of the banking system.

• Cash Reserve Requirement

All scheduled banks are required to deposit a certain percentage of their total liquid
assets with the State Bank. Technically, the government can bring about a change in
reserve requirement but normally the State Bank exercises this authority on the
government’s behalf. A rise in the cash reserve requirements restricts the bank’s
lending operations while a fall can encourage them to advance more credit.

• Selective Credit Control

The State Bank usually have considerable authority to control the composition of bank
credit. SBP can direct banks regarding the distribution of credit between different
sectors and uses, between long term and short-term loans, margin requirements for
advances against certain types of assets and the interest to be charged on different
types of advances and from different borrowers.
• Credit Ceiling

A credit ceiling for the banking system as a whole or for each individual bank, can
exercise some influence over the total volume of credit though not on its direction or
use.

• Liquidity Ratio

This is the ratio between a bank’s liquid resources and its total liabilities. While a low
liquidity ratio may lower public confidence in the banking system and may also allow
banks to liquidate their investments in government securities to finance credit
expansion, a high ratio adversely affects the credit flow in the economy and the
overall profitability of the bank.

• Open market operations

This consists of the purchase and sale of securities by the State Bank in the open
market. The quantity of cash in the money market increases with the purchase of
securities whereas their sale has contra-dictionary effect.

• Credit Quota

The State Bank can also limit its own lending to banks by fixing a credit quota for
each bank and borrowing over and above the limit may carry a higher interest rate.

In Pakistan, in addition to these instruments, the State Bank of Pakistan also offers
informal advice, guidance, and persuasion to banks in various matters. Such informal
control may have become fairly important particularly after the nationalization of
banks and the consequent unification of their operating policies.

Q.2 What are the negotiable instruments? Discuss in detail.

Ans. NEGOTIABLE INSTRUMENTS

Under the Negotiable Instruments Act, 1881 “a negotiable instrument means a

promissory note, bill of exchange or cheque payable either to order or to bearer”.
However, in general terms a Negotiable Instrument is one which is, by a legally
recognized custom of trade of law, transferable by delivery or by endorsement and
delivery in such circumstances that (a) the holder of it for the time being may sue on
it in his own name; and (b) the property in it passes, free from equities, to a bona
fide transferee for value, notwithstanding any defect with title of the transferor”.

CHARACTERISTICS

• Negotiable instruments are transferable from person to person like cash. In other
words, the property attributed to these instruments passes from one person to
another, either by endorsement or by delivery.

• The transferee of a negotiable instrument is entitled by law to sue on the

instrument in his own name in case of dishonour.

• A bona fide transferee of a negotiable instrument for value takes if free from all
defects in the title of his transferor. This is the main difference between negotiable
instrument and other subjects or ordering transfer.

KINDS

There are three main kinds of negotiable instrument:

• Bills of exchange;
• Cheques;
• Promissory notes;

These are discussed in detail as under:

BILLS OF EXCHANGE

“An instrument in writing, containing an unconditional order, signed by the maker,

directing a certain person, to pay certain sum of money, only to or to the order of a
certain person, or to the bearer of the instrument”.
Characteristics are:

• It must be in writing.
• It must be singed by the maker.
• It must contain an unconditional order.
• It must direct a certain person to pay a certain amount of money to a certain
person or his order or to bearer.
• It must be properly stamped.

PARTIES

There are generally three parties to a Bill of Exchange:

• Drawer: Drawer is the person giving the order.

• Drawee: Drawee is the person to whom the order is addressed.
• Payee or Endorsee: Payee or Endorsee is the person named in the instrument to
whom or to whose order the money is directed to be paid.

CHEQUE

“A cheque is defined as a bill of exchange drawn on a specified banker and not

expressed to be payable otherwise than on demand”. In general term, it is a bill of
exchange drawn on a banker which is payable on demand. A cheque is a peculiar type
of negotiable instrument which resembles a bill of exchange in particulars but does
not so resemble in other. Thus:

• a cheque does not require acceptance;

• it is not intended for circulation;
• but for immediate payment;
• it is not entitled to any days of grace;
• it is always drawn on a banker;
• it is payable to bearer on demand (unless crossed).

VARIETIES

• Open cheque:
This can be presented to the banker on whom they are drawn and paid by them “over
the counter”.

• Crossing:

This is a device adopted by the business community and sanctioned by law, which has
the effect of making cheques payable to a bank only or to a particular bank in an
account with such bank. Crossing is of two types. General crossing which consists of
drawing two parallel transverse lines, across the fact of cheque, either with or
without the words “not negotiable” and/or the words “and Co” in between. If in
addition to general crossing, the name of specified banker to whom the cheque is to
be payable, is also written on the face of the instrument, with or without the words
“not negotiable”, it is called special crossing”.

• Order cheque

This is a cheque (a) which is expressed to be so payable or (b) which is expressed to

be payable to a particular person, without containing words prohibiting transfer or
indicating that it shall not be transferable or (c) which is expressed to be payable to
the order of a certain person.

• Marked cheque

This means a cheque which is “marked” or certified by the banker on whom it is

drawn, to the effect that it would be honoured when presented for payment.

PROMISSORY NOTES

“This is an instrument in writing (not being a bank note or currency note) containing
an unconditional undertaking signed by the maker, to pay on demand or at a fixed or
determinable future time, a certain sum of money only, to or to the order of a
certain person or to the bearer of the instrument”

No precise form is necessary but the above definition lays down that the following
are the essentials of a Promissory Note:
• It must be an unconditional written promise.
• It must be singed by the maker called “promiser”.
• It must contain a promise to pay a certain sum in money only.
• The money should be payable to or to the order of a certain person or to the
bearer of the Promissory Note.
• It may be made by two or more persons and they may be liable thereon jointly and
severally.
• The amount promised in the Promissory Note must be payable on demand or at a
fixed or a determinable future time.

A Promissory Note is incomplete untill it has been delivered to the payee or the
bearer. Moreover, the sum promised in a Promissory Note can be made payable by
stated installments. The Promissory Note may be made by two or more makers who
may be liable thereon jointly and severally, according to is tenor.

Q.3 As a banker how would you appraise an industrial project? Support your answer
with arguments.

Ans. To appraise an industrial project, a banker has to make sure that five basic
prerequisites are fulfilled before taking decision. The five basic principles are:

• Safety;
• Maintaining liquidity;
• Maintaining wide dispersal;
• Financial advantage; and
• Economic Advantage.

SAFETY

The baker must be very careful while financing various projects because if the
ventures which he is financing are not viable then he will lose not only the bank’s
money but is likely to bring hardship to a large number of depositors. It must be kept
in mind that the depositor place their money at the disposal of the bankers because
they are sure of its safety. In view of the above, the bakers has to do a great deal
of thinking and homework before he allows finances for a certain venture. The
following matters have to be looked into by a banker most carefully to ensure safety
of the money:

• Character of the person or persons desirous of obtaining finances. He must be the

kind of person who can be trusted with the amount being provided to him.

• Previous record of their relationship with the baker has also to be considered. If a
party has been a client for a long period of time and his previous record shows that
he has honoured his commitments in the past, the banker can without any fear of the
future consequences provide finance.

• Capacity to honour their commitments and management ability are other factors
which have to be considered. A businessman may not have unlimited financial
resources but his capacity to manage investments may be of a high order in which
case the task of the bank becomes easy.

• The financial viability of the project is another factor because a party may have
large resources at his disposal and also have management capabilities but the project
which he proposes is doomed from the beginning because it is not financially viable.

MAINTAINING LIQUIDITY

• This means ability to convert assets into ready cash. The banker must make sure
that the money he is lending is not blocked for a long period of time so that it can be
lent to other people. The banker should always be hesitant to advance finances to
customers for purchase of fixed assets because this kind of asset cannot be changed
into liquid assets when needed.

MAINTAINING WIDE DISPERSAL

• The dispersal of the amount of advances should be broadly based so that a large
number of borrowing customers may benefit from the financing. The banker must
ensure that his funds are not invested in specific sector like textile industry, heavy
engineering or agriculture, etc. He must see that from his available funds he
advances them to a wide range of sector. Dispersal of advances is very necessary
from the point of security as well, because it reduces the risk of recovery when
something goes wrong in one particular sector.

FINANCIAL ADVANTAGE

• A banker needs sufficient amount of banking spread over the year so that he can
meet expenses which he has to meet in regard to interest paid to customers, payment
to dividend to shareholders, meeting the expenses and overhead, payment of salaries
and keeping adequate amount for financing future investments. Banking itself is a
business and therefore, the banker must always keep in mind that he has to create
conditions of financial advantage.

ECONOMIC ADVANTAGE

• The bankers have always keep in sight the overall nature of economic and social
objectives of development in the country. For this purpose he has got to think in
terms of economic advantage of the nation as a whole upper most in his mind and see
that the projects financed by him are in line with national objectives.

Q.4 Write notes on the following:-

1. LETTER OF CREDIT

Ans. In export and import, both importer and exporter may be not known to each
other. When an importer is not particularly well known to an exporter, but the
transaction is being conducted directly between the importer and exporter, then they
use the services of a bank through a letter of credit, which is also known as
Documentary Credit. A letter of credit is a satisfactory way of ensuring payment
before control of the goods is surrendered. The usual way in which this is effected
by an irrevocable letter of credit which may be confirmed in certain cases. A really
detailed understanding of letter of credit is necessary for all those who are engaged
in international trade. A documentary credit is an understanding by a bank at the
request of its customer, an importer, to pay an exporter or accept the exporter’s
term bill of exchange in respect of goods consigned to the importer when satisfactory
documents including evidence of shipment and all other documents required under the
terms of the credit are produced at a named place within a specified period.
TYPES

• Revocable credit.

A revocable credit gives no undertaking to the exporter that payment will actually be
made because it may be cancelled or amended at any time without prior notice to the
beneficiary.

• Irrevocable letter of credit.

An irrevocable credit constitutes a definite undertaking of the issuing bank, provided

that the stipulated documents are presented and that the terms and conditions of
credit are complied with. The issuing bank, in case of irrevocable credit gives a
binding or definite undertaking to the beneficiary that he will pay against documents
or that the bills drawn in compliance with the terms of credit will be honoured.

• Confirmed letter of credit.

When an issuing bank authorizes or requests another bank to confirm its irrevocable
credit and the latter has added its confirmation, such confirmation constitutes a
definite undertaking of such bank, in addition to that of the issuing bank, provided
that the stipulated documents are presented according to the terms and conditions of
the credit. The beneficiary of such credit has a double assurance of getting his
money, the undertaking by his bank and the issuing bank. The confirmed credit
eliminated practically all the risks to the seller.

• Unconfirmed letter of credit.

In this type, these credit are carried with undertaking by the opening bank but not
confirmed by the advising bank. The majority of credits covering international trade
are irrevocable credits but most of them are not confirmed. The reason is that buyer
is not prepared to pay an additional charge for confirming the credit or it may effect
on the cost of the goods by the seller.

• Sight and acceptance letter of credit

There are two categories of credit in connection with payment; (i) sight letter of
credit which means that the payment is to be made on demand or on presentment of
bill of exchange; and (ii) acceptance letter of credit in which type facility in payment
is allowed to the buyer i.e., payment on 30, 60, 90 days document against
acceptance basis.

• Revolving credit.

A credit which contains a condition that the credit amount is to be renewed or

reinstated automatically in stated circumstances without the need for further specific
amendment. A credit revolve around amount or around time. A credit which revolves
in relation to time is for more usual and practical instrument.

2. ENDORSEMENT

An endorsement means the writing of a person’s name on the back of a negotiable

instrument; This can be given also on the face of an instrument. It has no particular
form of words and can be given on a piece of paper annexed to a negotiable
instrument. It should be given for the purpose of negotiation which has been defined
in section 14 of the Negotiable Instrument Act, 1881.

Classes of endorsement are:

• Blank & Full endorsement: In Blank, it consists of the bare signature of the
endorser and the instrument so endorsed becomes payable to bearer. In Full, it
specifies, in addition to the signature of the endorser, the person to whom or to
whose order the instrument is payable.

• Restrictive Endorsement: This prohibits further negotiation of the instrument i.e.,

the endorsee has no power to transfer this rights to any one further.

• Partial Endorsement: This purports to transfer to the endorsee only a part of the
amount payable on a bill of exchange or promissory note.
• Conditional Endorsement: This makes the transfer of the instrument from the
endorser to the endorsee after the fulfillment of stated conditions.

• “Sans Recourse” Endorsement: When an endorser wants to exclude his liability to

the endorsee or subsequent holder he indicates it clearly on the instrument by writing
the words “SANS RECOURSE” or “Without Recourse”.

Bankers in Pakistan accept endorsements in the following forms:

• Endorsements by:
- individuals
- married women
- illiterate persons
- agents for individuals
- joint payees
- firms
- joint stock companies
- clubs, societies and association, etc.
- official payees
- executors and administrators
- trustees
- public bodies.

The liabilities of an endorser are:

• like the drawer of a bill of exchange or cheque, the endorser of these instruments
is only a surety for the principal debtor and his liability is secondary and conditional.

• By endorsing the negotiable instrument, the endorser takes the liability of

acceptance or payment of the endorsed instrument when it falls due, according to its
apparent tenor.

• If the endorsed instrument is dishonored, the endorser is liable to compensate the

holder for the loss or damage which he may sustain on account of such dishonour.

Q.5 Discuss the steps taken by the Government of Pakistan to develop interest free
banking system so far.

Ans. LATEST DEVELOPMENT

In the recent past, the Appellate Bench of the Supreme Court has pronounced its
verdict upholding the earlier Judgement of the Shariat Court declaring all interest
(Riba) based transactions as un-Islamic. The Judgement of the Appellate Bench of
the Supreme Court on Riba is the latest development in interest free banking in
Pakistan and in the right direction for doing away with the present exploitative
economic and banking system. The Bench has declared that all laws dealing with
payment of interest as un-Islamic which shall cease to effect from June 30, 2001 in
Pakistan. With this historic Judgement, Pakistan becomes the only country, amongst
the Muslim states, where the interest has been outlawed from all segments of the
economy. The government has, however, clarified that as a result of the verdict
given by the Supreme Court, obligations to the foreign government, banks, financial
institutions and other entities remained unaffected by the Judgement of the Shariat
Appellate Bench on Riba. All laws currently applicable to financial contracts,
agreements, transaction, etc., will continue to remain in force as before until new
laws are replace the old laws for which a time frame has been given by the
Judgement itself which is June 2001.

The salient features are:

• Establishment of a commission for transformation in the State Bank of Pakistan

that will be responsible for developing and preparing the groundwork for such methods
of financial dealings as will be in conformity with the principles of Islam.

• Formation of a committee of experts in the Ministry of Law to recommend

legislative changes required to support the new arrangements and to suggest
amendments in other laws to bring them in conformity with the requirements of
Islamic Law.

• Formation of a task force in the Ministry of Finance to study and suggest methods
for domestic borrowings by the government which will be in conformity with the
requirements of Islamic Law.
• All the contracts, arrangements and laws would remain so till such time that the
modified arrangements were worked out in the light of the recommendations of the
commission for transformation to be set up in the State Bank of Pakistan.

HISTORICAL REVIEW

The need for elimination of Riba from the economy and ordering Pakistan’s economic
life according to the teachings of Islam was voiced by experts soon after
independence in 1947. Inspite of early interest shown in the problems of devising and
implementing an economic system based on Islam no significant developments took
place until 1999 when the President of Pakistan announced that Council of Islamic
Ideology should prepare a plan so that interest can be eliminated from the economy
within three years. The Council in June 1980 gave its formal report to the
Government in which attempted to lay down the guidelines for the reorientation of
financing operations of commercial banks in the country in such a way that the system
will be in accordance with the tenets of Islam. As far the implementation of the non-
Interest Banking system a gradual progressive method was adopted:

• First Step (1979)

Operations of NIT, ICP & HBFC were rescheduled on a non-interest based system.

• Second Step (1981)

A system of PLS saving accounts was introduced. Interest free counters were opened
at all branches of commercial banks.

• Third Step (1981)

On Participation Term Certificates arrangements the commercial banks were allowed

to provide finances to limited customers.

• Fourth Step (1982)

The system of House Building Finance on rent sharing based by commercial banks was
introduced.
• Fifth Step (1983)

The Hire-Purchase financing scheme on rent sharing bases was introduced.

• Sixth Step (1984)

All banking companies were allowed to make finances on the following 12 modes of
financing allowed by the State Bank:

- Qard-e-Hasana
- Loans with Service charge
- Purchase and sale of goods by banks on mark up basis.
(Murabaha)
- Purchase of trade bills.
- Purchase of movable/immovable property by banks with
buy-back agreements
- Leasing
- Hire purchase
- Financing for development of property on the basis
of a development charge.
- Musharika
- Equity participation and purchase of shares
- Purchase of participation term certificates and
modaraba certificates
- Rent sharing.

• Seventh Step (1985)

All finances provided by banking companies to federal and provincial governments,

public sector corporations and public or private sector and joint stock companies were
to be only given in one of the 12 non-interest modes prescribed the State Bank.

• Eight Step (1985)

All finances provided by banking companies to all entities including individuals were
charged to non-interest system as contended in the 12 prescribed modes.

• Ninth Step (1985)

The banks were prohibited from accepting any interest bearing deposits