Principles of lending

Principles of lending

The business of lending, which is main business of the banks, carry certain inherent risks and bank cannot take
more than calculated risk whenever it wants to lend. Hence, lending activity has to necessarily adhere to certain
principles. Lending principles can be conveniently divided into two areas (i) activity, and (ii) individual.
(i) Activity:

(a) Principle of Safety of Funds
(b) Principle of Profitability
(c) Principle of Liquidity
(d) Principle of Purpose
(e) Principle of Risk Spread
(f) Principle of Security

(ii) Individual :

(a) Process of Lending
(b) 5 ‘C’s of the borrower = Character, Capacity, Capital, Collateral, Conditions Sources of information available to assess the borrower

– Loan application
– Market reports
– Operation in the account
– Report from other Bankers
– Financial statements, IT returns etc.
– Personal interview
– Unit inspection prior to sanction

(c) Security Appraisal
Primary & collateral security should be ‘MASTDAY’

M – Marketability
A – Easy to ascertain its title, value, quantity and quality.
S – Stability of value.
T – Transferability of title.
D – Durability – not perishable.
A – Absence of contingent liability. I.e. the bank may not have to spend more money on the security to make it marketable or even to maintain it.
Y – Yield. The security should provide some on-going income to the borrower/ bank to cover interest & or partial repayment.

The traditional principles of bank lending have been followed with certain modifications. The concept of security
has undergone a radical change and profitability has been subordinated to social purpose in respect of certain
types of lending. Let us now discuss the principles of lending in details:

Safety

As the bank lends the funds entrusted to it by the depositors, the first and foremost principle of lending is to
ensure the safety of the funds lent. By safety is meant that the borrower is in a position to repay the loan, along
with interest, according to the terms of the loan contract. The repayment of the loan depends upon the borrower’s
(a) capacity to pay, and (2) willingness to pay. The former depends upon his tangible assets and the success of
his business; if he is successful in his efforts, he earns profits and can repay the loan promptly. Otherwise, the
loan is recovered out of the sale proceeds of his tangible assets. The willingness to pay depends upon the
honesty and character of the borrower. The banker should, therefore, taken utmost care in ensuring that the
enterprise or business for which a loan is sought is a sound one and the borrower is capable of carrying it out
successfully. He should be a person of integrity, good character and reputation. In addition to the above, the
banker generally relies on the security of tangible assets owned by the borrower to ensure the safety of his
funds.

Liquidity

Banks are essentially intermediaries for short term funds. Therefore, they lend funds for short periods and mainly
for working capital purposes. The loans are, therefore, largely payable on demand. The banker must ensure that
the borrower is able to repay the loan on demand or within a short period. This depends upon the nature of assets
owned by the borrower and pledged to the banker. For example, goods and commodities are easily marketable
while fixed assets like land and buildings and specialized types of plant and equipment can be liquidated after a
time interval. Thus, the banker regards liquidity as important as safety of the funds and grants loans on the
security of assets which are easily marketable without much loss.

Profitability

Commercial banks are profit-earning institutions; the nationalized banks are no exception to this. They must
employ their funds profitably so as to earn sufficient income out of which to pay interest to the depositors, salaries
to the staff and to meet various other establishment expenses and distribute dividends to the shareholders (the
Government in case of nationalized banks). The rates of interest charged by banks were in the past primarily
dependent on the directives issued by the Reserve Bank.

Now banks are free to determine their own rates of
interest on advances.. The variations in the rates of interest charged from different customers depend upon the
degree of risk involved in lending to them. A customer with high reputation is charged the lower rate of interest as
compared to an ordinary customer. The sound principle of lending is not to sacrifice safety or liquidity for the sake
of higher profitability. That is to say that the banks should not grant advances to unsound parties with doubtful
repaying capacity, even if they are ready to pay a very high rate of interest. Such advances ultimately prove to be
irrecoverable to the detriment of the interests of the bank and its depositors.

Purpose of the Loan

While lending his funds, the banker enquires from the borrower the purpose for which he seeks the loan. Banks
do not grant loans for each and every purpose—they ensure the safety and liquidity of their funds by granting
loans for productive purposes only, viz., for meeting working capital needs of a business enterprise. Loans are
not advanced for speculative and unproductive purposes like social functions and ceremonies or for pleasure
trips or for the repayment of a prior loan. Loans for capital expenditure for establishing business are of long-term
nature and the banks grant such term loans also. After the nationalization of major banks loans for initial expenditure to start small trades, businesses, industries, etc., are also given by the banks.

Principle of Diversification of Risks

This is also a cardinal principle of sound lending. A prudent banker always tries to select the borrower very
carefully and takes tangible assets as securities to safeguard his interests. Tangible assets are no doubt
valuable and the banker feels safe while granting advances on the security of such assets, yet some risk is
always involved therein. An industry or trade may face recessionary conditions and the price of the goods and
commodities may sharply fall. Natural calamities like floods and earthquakes, and political disturbances in
certain parts of the country may ruin even a prosperous business.

To safeguard his interest against such unforeseen contingencies, the banker follows the principle of diversification of risks based on the famous maxim “do not keep all the eggs in one basket.” It means that the banker should not grant advances to a few big firms only or to concentrate them in a few industries or in a few cities or regions of the country only.

The advances, on the other hand, should be over a reasonably wide area, distributed amongst a good number of
customers belonging to different trades and industries. The banker, thus, diversifies the risk involved in lending.
If a big customer meets misfortune, or certain trades or industries are affected adversely, the overall position of
the bank will not be in jeopardy