Overdraft Facility

An overdraft facility is a flexible short-term credit arrangement that allows an account holder to withdraw funds in excess of the available balance in a bank account, up to a pre-approved limit. In the Indian banking and financial system, overdraft facilities are widely used by individuals, businesses, and institutions to manage temporary liquidity mismatches and working capital requirements. They play an important role in credit delivery, cashflow management, and the smooth functioning of economic activity.
In India, overdraft facilities are particularly significant for businesses that experience fluctuating cashflows, as well as for individuals seeking short-term financial flexibility without committing to long-term borrowing.

Concept and meaning of overdraft facility

An overdraft facility permits a customer to overdraw their current or, in some cases, savings account up to a sanctioned limit agreed with the bank. The customer pays interest only on the amount actually utilised and for the duration of use, making it a cost-efficient form of short-term borrowing.
Unlike term loans, overdrafts do not have a fixed repayment schedule. Repayments are flexible and linked to cash inflows into the account, allowing borrowers to adjust utilisation based on their liquidity position.

Types of overdraft facilities in India

Overdraft facilities in India can be broadly classified into <u>secured</u> and <u>unsecured</u> overdrafts. Secured overdrafts are backed by collateral such as fixed deposits, property, shares, or insurance policies. These carry lower interest rates due to reduced credit risk.
Unsecured overdrafts, also known as clean overdrafts, are granted based on the borrower’s creditworthiness, account conduct, and income profile. These are more common for well-established businesses or salaried individuals with strong financial standing and generally attract higher interest rates.

Regulatory framework and banking norms

Overdraft facilities in India are governed by prudential and operational guidelines issued by the Reserve Bank of India. Banks are required to assess borrower eligibility, set appropriate limits, monitor account operations, and classify assets in line with regulatory norms.
The RBI also prescribes standards for income recognition, asset classification, and provisioning for overdraft and cash credit accounts. Accounts that are irregular or persistently overdrawn may be classified as stressed assets or non-performing assets, depending on regulatory criteria.

Role in working capital management

Overdraft facilities are a key instrument of working capital finance in India. They allow businesses to meet day-to-day operational expenses such as wages, inventory purchases, and utility payments while waiting for receivables to be realised.
For micro, small and medium enterprises, overdrafts provide crucial liquidity support, particularly in sectors with long operating cycles or seasonal demand patterns. The revolving nature of overdrafts aligns well with the cashflow needs of such businesses.

Importance for banks and financial institutions

For banks, overdraft facilities generate interest income and strengthen customer relationships. They also provide valuable insights into borrower cashflows through continuous monitoring of account activity.
However, overdrafts require close supervision, as prolonged or excessive utilisation may indicate financial stress. Banks therefore use overdraft performance as an early warning signal for credit risk management.

Impact on the Indian economy

At the macroeconomic level, overdraft facilities support economic stability by smoothing cashflow fluctuations for households and businesses. They facilitate uninterrupted production, trade, and consumption, particularly in sectors dependent on short-term liquidity.
Efficient use of overdraft facilities reduces reliance on informal credit sources, promoting financial inclusion and formalisation of economic activity. By supporting timely payments within supply chains, overdrafts also contribute to overall economic efficiency.

Risks and limitations

Despite their flexibility, overdraft facilities carry certain risks. Uncontrolled or prolonged overdraft usage can lead to high interest costs and debt accumulation. From a banking perspective, unsecured overdrafts pose higher credit risk and require robust monitoring.
Economic downturns can increase the incidence of irregular overdraft accounts, affecting asset quality. Therefore, both borrowers and banks must manage overdraft facilities prudently.