Principle of Bank

Lending
Chapter 6
 CONTENT
Different kinds of borrowing facilities granted by banks such as:
• Loans
• Lien
• Pledge
• Mortgage
• Life policies
• Land & Building
• Cash Credit
• Overdraft
• Bills Purchased & Bills Discounted Facility
• Letters of Credit
• Types of securities
• NPA
• RBI guidelines for 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:
• Principle of Safety of Funds
• Principle of Profitability
• Principle of Liquidity
• Principle of Purpose
• Principle of Risk Spread
• Principle of Security
1. Safety: safety is the most important principles of lending. A banker has to see
that the borrower should be able to repay the principle amount along with
interest.
2. Profitability : in order to ensure sufficient profit a bank should employ its fund
in genuine sources which gives not only fair returns but also steady returns.
3. Liquidity: liquidity refers to convertibility into cash. The major portion of bank
deposits is repayable on demand or at a short notice. Therefore the banks must
see to it that advances are not locked up but comes back immediately.
4. Purpose : A banker should grant advance for productive purposes such as
financing trade, commerce and industry. He should not grant advances for
unproductive purposes.
5. Diversification of Risk: Another important principle to be followed by the
banker is to see that loans and advances are spread to different categories.
6. Security : Another guiding factor in bank advance is security. When the banker
advances without security he will run the risk of losing the money.
II. INDIVIDUAL :
5 ‘C’s of the borrower = Character, Capacity, Capital, Collateral,
Conditions
1. CHARACTER
• What it is: A lender’s opinion of a borrower’s general trustworthiness,
credibility and personality.
• Why it matters: Banks want to lend to people who are responsible and
keep commitments.
• How it’s assessed: From credentials, references, reputation and
interaction with lenders.
2. CAPACITY/CASH FLOW
• What it is: Your ability to repay the loan.
• Why it matters: A business must generate enough cash flow to repay the loan.
Loans are a form of debt, and they must be repaid in full.
• How it’s assessed: From financial metrics and benchmarks (debt and liquidity
ratios, cash flow statements), credit score, borrowing and repayment history.
3. CAPITAL
• What it is: The amount of money invested by the business owner or
management team.
• Why it matters: Banks are more willing to lend to those who have invested
some of their own money into the venture. Most lenders are not willing to take on
100% of the financial risk, so it helps borrowers to have some “skin in the game.”
• How it’s assessed: From the amount of money the borrower or management
team has invested in the business.
4. COLLATERAL
• What it is: Assets that can be pledged as security.
• Why it matters: Collateral acts a backup source if the borrower cannot repay a loan.
• How it’s assessed: From hard assets such as real estate and equipment; working
capital, such as accounts receivable and inventory; and a borrower’s home that also
can be counted as collateral.
5. CONDITIONS
• What it is: How the business will use the loan and how that could be affected by
economic or industry factors.
• Why it matters: To ensure that loans are repaid, banks want to lend to businesses
operating under favourable conditions. They want to identify risks and protect
themselves accordingly.
• How it’s assessed: From a review of the competitive landscape, supplier and customer
relationships, and macroeconomic and industry-specific issues to ensure that risks are
identified and mitigated.
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.
 TYPES OF CREDIT FACILITIES
Credit facilities extended by banks to customers/borrowers
are:
1. Fund Based Credit Facilities: Such credit facilities provide funds to
borrowers for:
(i) Working Capital, and
(ii) Capital Expenditure/Project Finance including deferred payment
guarantee.
2. Non- Fund Based Credit Facilities:
i. Letter of Credit
ii. Bank Guarantee
 TYPES OF CREDIT FACILITIES
Credit facilities extended by banks to customers/borrowers are:
1. Fund Based Credit Facilities: Such credit facilities provide funds to borrowers for:
(i) Working Capital, and
(ii) Capital Expenditure/Project Finance
i. Working Capital Finance: These facilities are granted for a short period, generally
upto one year and are renewed/rolled over from year to year depending upon the
fresh assessment of the requirements of the borrower(s). They are provided by way
of:
a. Cash Credit
b. Overdraft
c. Demand Loans/
d. Bill Finance (Bills Purchased and Bills Discounted)
Fund Based Credit Facilities
a. Cash Credit:
❖It is a unique credit facility offered by banks in India. It is running account of
drawing of funds with 3 features, namely (i) credit limit/line of credit (ii) drawing
power and (iii) actual drawls.
❖The borrowers can draw funds within specified credit limit sanctioned by the
bank against the security of inventory (stock) and receivables (book debts)
which are pledged/hypothecated by the borrowers
❖The borrower(s) submits monthly statements of the charged assets and the
bank permits him to draw cash/cheques within the drawing power, that is, the
value of the pledged assets less the stipulated margin, that the cash credit
account can sustain. The bank undertakes continuous verification of the actual
inventory/receivables of the borrower. The borrower has to pay interest on
actual withdrawals/daily debit balances in the account. The borrower deposits
the sale proceeds in the cash credit account.
b. Overdraft: A Bank Overdraft is drawing from a current account in
excess of credit balance. Bank sanction an overdraft limit for a specified
purpose/period. Overdraft can be both secured and unsecured.
Drawings can be made upto a sanctioned limit and interest is charged
on the daily debit balance in the account.
c. Demand Loan: A demand loan is a one-time facility subject to
periodic/lumpsum/principal repayment along with the monthly/quarterly
interest payment. The loan is fixed amount advanced to the borrower
initially for a specific purpose, generally upto one year. No subsequent
withdrawals are allowed.
d. Bills Purchased/Discounted: A bill of exchange is drawn by a seller
(drawer) on the purchaser of goods (drawee) directing the drawee to pay
the specified amount as per the terms of credit. A bill can be (i) demand
bill payable on demand (ii) usance bill payable on the expiry of credit
period, normally upto three months.
Procedure of Bills Purchases/Discount
➢The seller (drawer) submits the bills along with the transportation (i.e
rail/lorry/air/ bill of lading) receipts and document of title to goods to his
bank who sends the documents to the drawee for presentment for
payment (demand bill)/acceptance (usance bill).
➢The sellers’ bank purchases the demand bills and discounts the usance
bills by crediting the drawer’s account with the bill amount less the
interest/discount.
➢In case of non-payment of bills on the due date, the drawer would have to
pay the bill amount together with additional interest. The bank ensures
that the bills purchased/discounted are genuine and represent specific
transaction of sale of goods between the seller and the purchaser.
 Fund Based Credit Facilities: Capital Expenditure/Project
Finance
Term loans are given by banks for capital expenditure, that is, acquisition of fixed
assets for setting up a new unit or modernisation/expansion/diversification of an
existing one.
A detailed project appraisal in terms of the (technical/commercial/managerial
viability and (ii) financial viability/debt servicing capacity is carried out by the bank
before sanctioning the loan. The loan is secured by mortgage of either the specific
fixed assets financed or the entire block of fixed assets of the borrower. The loan is
repaid by the borrower from its cash accruals in equated monthly instalments over
the loan tenure. In addition to the mortgage of assets coupled with the promoters
guarantee, banks introduce some positive/negative covenants/conditions in terms
of minimum working capital, restrictions on dividends, restraint on further
borrowings and so on in the loan agreement to ensure financial discipline by the
borrower(s).
Non-Fund Credit facility
Such facilities do not involve outlay of funds and are fee-based. They are a
sort of a commitment to honour certain promises and are known as off-
balance (liability) items. However, outlay of funds is contingent upon the
devolvement of the commitments (contingent liability). Included in such
facilities are:
i. Letter of Credit, and
ii. Bank Guarantees
Letter of Credit (L/C)
A letter of credit is an arrangement whereby a bank (issuer), at the
request of a customer (opener of L/c), undertakes to pay the named
beneficiary (seller) by a specified date, against date, against the
presentation of the specified document (s), the value of the
goods/services. An L/C involves three parties:
i. Issuing bank
ii. Opener (buyer) and
iii. Beneficiary (seller)
The seller supplies goods to the buyer and tenders the consignment
documents to the issuing bank against its undertaking in the L/C, who
makes payment of the bills and recovers the payment from the buyer.
Letter of Credit (L/C)
An LC may be issued on a D/P (deliverable on payment) or DA
(deliverable against acceptance) basis as regards the delivery of the
documents of title to goods to the buyer to enable him to take delivery of
the goods. It may be inland for domestic trade or cross border for
overseas trade. The bank charges commission on issuance of L/C and
interest for negotiating documents under the L/C.
Bank Guarantee
A bank guarantee is a 'letter of guarantee' issued by a bank on behalf of its
customer, to a third party (the beneficiary) guaranteeing that certain sum of
money shall be paid by the bank to the third party within its validity period
on presentation of the letter of guarantee.
A letter of guarantee usually sets out certain conditions under which the
guarantee can be invoked. Unlike a line of credit, the sum is only paid if the
opposing party does not fulfil the stipulated obligations under the contract.
A bank guarantee is usually used to insure a buyer or seller from loss or
damage due to non-performance by the other party in a contract.
 Types of Securities
If a borrower fails to repay the advance, a banker should have
adequate cushion or cover to protect his interest. A security is
meant to be an insurance against such an emergency and its
role as one of the main considerations for sanctioning an
advance cannot be undermined.
1. Tangible and Intangible Security
2. Secured and Unsecured Advances
3. Primary and Collateral Security
Tangible and Intangible Security
Securities like raw materials, finished goods, agricultural produce, machineries,
land and building, shares and debentures, fixed deposit receipts, life insurance
policies, documents to title of goods, are those that have a physical form and are,
therefore, called ‘tangible securities’. In addition to tangible securities is not
available, a banker can also take intangible securities, like guarantees of reputed
persons to cover an advance. In case of need, the bank calls upon the
borrowers/guarantors in their personal capacity to repay the advance.
Secured and Unsecured Advances
When sufficient tangible security is available to cover the amount of advance, it is
called a secured advance. When tangible security is not available to back the
advance, or is not sufficient to cover the advance in case of need, it is called an
unsecured advance.
Primary and Collateral Security
Primary security is the security which the borrower himself offers to a
banker as the main security for an advance. Suppose, M/s Ashok Kumar &
Co. approach a bank for an advance of Rs. 10 lakh by way of cash credit
offering the security of hypothecation of raw materials for manufacturing
plastic toys. Such security is called primary security.
Collateral security is the additional security which the banker may insist
upon as it helps him to realise his dues in case the primary security defaults.
If in the above case M/s Ashok Kumar & Co. also offer their industrial
shed/plot as a security by way of mortgage, it will be a collateral security to
fall back upon as a second cushion.
 Advances Against Various Securities
• Land & Building
• Life policies
Land & Buildings
Financial Institutions, like IDBI, ICICI,IFCI,SIDBI,IRBI cater to long-term
needs of entrepreneurs. They accept security of plant and machinery as
mortgage. Sometimes, banks also share such advance with the financial
institutions and accept second mortgage of land and buildings. Whenever
banks give direct long-term or medium term loan to entrepreneurs, they
first accept mortgage of and buildings.
A banker has to get a clear title report from its approved advocate/solicitor
as well as a valuation report from an approved valuer. A certificate under
Urban land ceiling Act, if required and formalities about payment of taxes,
stamp duty, execution of documents must be completed before going in for
mortgage of fixed assets, like land and buildings.
Life Insurance Policy
A banker sometimes grants advance against a life insurance policy issued
by the Life Insurance Corporation of India. These policies are of many
kinds, such as whole life policy, endowment policy, anticipated policy,
education policy, marriage policy, etc. Sometimes, these policies are
accepted as collateral securities.
A banker has to be careful while granting advances life insurance policies.
The surrender value of a policy starts only when it has run for at least three
years. Surrender value of the policy and full particulars of the policies
offered as security must be ascertained carefully. A margin of about 15% on
the surrender value is a sufficient margin on life policies. Policies must be
assigned in favour of a bank before an advance is granted.
 Methods of Charging Securities
Creating a charge on a security or charging a security refers to the
procedure by which a banker establishes his right as a lender on the
particular security offered by the borrower.
1. Lien
2. Pledge
3. Mortgage
1. Lien: A lien empowers a bank to retain all the securities/assets of
the customers in respect of the balance due from him.
• Although the ownership in securities vests in the customers, the
bank gets the right to sell them under the specified
circumstances.
Under Negative lien, the bank does not have the right to retain
any assets/is not entitled to realise dues from such assets but the
borrower submits a declaration to the bank to the effect that the
specified assets are free from any charge/encumbrance and no
charge would be created against them and /or they would not be
disposed of without the permission of the bank.
2. Pledge : A contract where by a borrower (pledger) offers his tangible property
to his lender (bank/pledgee) as a security for the amount borrowed on the
understanding that the property pledged will be returned when the debt is
repaid.
• The goods pledged are only movable goods.
• The ownership in pledged goods continues to remain with the pledger but
their possession is given to the pledgee.
• The pledgee gets the right to sell the goods if the pledger fails to repay the
loan within the stipulated time.
• Alternatively, it may file a suit against the pledger to recover the debt while
retaining the pledged goods as security.
• Upon repayment of the debt covered by the pledge, the banker has to return
the goods to the pledger.
• During possession of the goods, the bank must take adequate and
reasonable care of the goods as if they belong to him.
3. Mortgage
Mortgage is the transfer of interest in a specified immovable property for
the purpose of securing the payment of money advanced/to be
advanced by way of loan/an existing or future debts/the performance of
an agreement which may give rise to a pecuniary liability.
In other words, mortgage is a charge on an immovable property to cover
a loan/advance (mortgage money).
• Ownership and possession of the property remains with the borrower
(mortgagor) but some of the interest in the property is transferred to
the /transferee (mortgagee) through a mortgage deed.
• A mortgage can be created for present as well as future debt(s). If the
mortgager is a company, the mortgage charge must be registered with
the ROCs within 30 days from the date of its creation.
 NPA
A non-performing asset (NPA) is a loan or advance for which the principal or interest payment
remained overdue for a period of 90 days.
Description: Banks are required to classify NPAs further into:
1. Substandard,
2. Doubtful, and
3. Loss assets.
1. Substandard Assets: Assets which has remained NPA for a period less than or equal to
12 months.
2. Doubtful Assets: An asset would be classified as doubtful if it has remained in the
substandard category for a period of 12 months.
3. Loss Assets: As per RBI, “Loss asset is considered uncollectible and of such little value
that its continuance as a bankable asset is not warranted, although there may be some
salvage or recovery value.”