Let’s get very clear about one thing: When you deposit money in a bank, your money doesn’t sit in the bank’s vault. It becomes the bank’s money upon deposit. The bank simply owes it back to you or to your order upon demand (a withdrawal or presentment of a check). You, in other words, have become the bank’s creditor for the amount of your deposits.
When you also have a loan from that same bank, the bank is your creditor. And where there are mutual debts, that is, where the parties are both creditors and debtors of each other, the common law and practically all bank deposit agreements allow the debts to be set off against one another. So, if the depositor’s loan from the bank goes into default, the bank can simply credit the deposit account (the bank’s debt to its customer) against the amount owed on the loan (the customer’s debt to the bank).
A bank can also exercise its rights of set-off even where the depositor has filed bankruptcy. The bank merely has to freeze the customer-debtor’s bank account to prevent the debtor from cleaning out the bank account, and then ask the court for relief from the automatic stay to implement the set off.
There are a few exceptions to a bank’s right of set-off. For instance, there are regulatory restrictions on banks set off for consumer loans incurred for personal, family or household purposes, as opposed to business loans. Also, the debtors must be identical. The customer on the deposit account must be the same person as the borrower on the bank alone, and not acting in a different capacity, such as a trustee, an executor or an escrow agent.
The right of the bank to set off is as old as the hills, and makes perfect sense. However, lenders and borrowers should be alert and careful that the right is legitimately exercised.