Principles of Lending are the time-tested rules and guidelines that a banker follows to ensure that the loans they provide are safe, secure, and profitable. Following these principles helps minimize the risk of a loan becoming a Non-Performing Asset (NPA).
Think of these principles as a banker’s safety checklist before giving out a loan.
The Core Principles of Sound Lending
Here are the most important principles every banker must consider.
1. Principle of Safety
- What it is: This is the most important principle. It means the money lent out must be safe and should come back.
- How it’s ensured: The banker must be satisfied with the borrower’s capacity to repay (their income and financial health) and their willingness to repay (their character and credit history).
- Example: Before giving a home loan, a banker thoroughly checks the applicant’s salary slips, income tax returns, and CIBIL score to ensure they have a stable income and a good track record of paying back past loans.
2. Principle of Liquidity
- What it is: Liquidity means the ability to get the money back easily and on time.
- How it’s ensured: Banks lend for short to medium terms and ensure that the loan repayment schedule matches the borrower’s cash flow. Banks use depositors’ money, which can be withdrawn on demand, so they cannot lock up all their funds in very long-term loans.
- Example: A bank would prefer to give a 1-year working capital loan to a business that has regular sales, rather than a 20-year loan to a project with uncertain returns.
3. Principle of Profitability
- What it is: Banks are commercial organizations and must earn a profit to survive.
- How it’s ensured: The bank must charge an appropriate interest rate on the loan. The interest earned must be sufficient to cover the bank’s own borrowing costs, operational expenses, and the risk involved, while still leaving a profit margin.
- Example: A bank charges a higher interest rate on an unsecured personal loan compared to a secured home loan because the risk of default is higher.
4. Principle of Purpose of Loan
- What it is: The bank must know the exact purpose for which the borrower is taking the loan.
- How it’s ensured: The loan should be for a productive or legitimate purpose. The bank must also ensure that the money is used for the stated purpose and not diverted elsewhere.
- Example: If a loan is given for buying machinery, the bank ensures the money is paid directly to the machinery supplier. This prevents the borrower from using the funds for speculative activities.
5. Principle of Security
- What it is: The bank should generally ask for some form of collateral or security against the loan.
- How it’s ensured: The security can be tangible (like a house, car, or gold) or intangible (like a guarantee). This security acts as a backup for the bank to recover its money if the borrower fails to repay.
- Example: For a home loan, the house itself is the security (mortgaged to the bank). For a car loan, the car is the security (hypothecated to the bank).
6. Principle of Diversification of Risk
- What it is: This is the principle of “don’t put all your eggs in one basket.”
- How it’s ensured: A bank should not lend a large amount of its funds to a single borrower, a single industry, or a single geographical area. It should spread its loans across many different types of borrowers and industries.
- Example: A bank avoids lending too much money only to the textile industry. Instead, it lends to a mix of sectors like agriculture, manufacturing, services, and retail to diversify its risk.
Summary
The principles of lending are the pillars of a sound and healthy credit portfolio for any bank. They ensure a careful balance between safety, liquidity, and profitability. By assessing the borrower’s character and capacity (Safety), ensuring timely repayment (Liquidity), charging appropriate interest (Profitability), understanding the end-use of funds (Purpose), taking adequate collateral (Security), and spreading the risk (Diversification), a banker can minimize lending risks and contribute to the bank’s stability and growth.
Quick Revision Points
- Diversification: Are the loans spread across different borrowers and industries?
- Safety: Is the borrower able and willing to repay? (Check CIBIL score & income).
- Liquidity: Will the money come back on time? (Match repayment with cash flow).
- Profitability: Is the bank earning enough interest to cover costs and risk?
- Purpose: Is the loan for a productive and genuine reason?
- Security: What is the backup (collateral) if the borrower defaults?
Categories of Borrowers
Borrowers can be broadly divided into two main categories:
- Individuals
- Non-Individuals (or Legal Entities)
1. Individual Borrowers
These are natural persons who apply for loans in their personal capacity.
a) Individuals (Majors)
- Who they are: Any person who has attained the age of 18 years.
- Key Consideration: They must be of sound mind and not disqualified by any law. This is the most common type of borrower for retail loans like home, car, or personal loans.
b) Minors
- Who they are: A person who has not completed 18 years of age.
- Key Consideration: A contract with a minor is void (not legally enforceable). Therefore, a bank cannot lend money to a minor.
- Exception: A loan can be given to a minor’s guardian for the minor’s benefit (e.g., for education), but the minor is not personally liable to repay.
c) Joint Borrowers
- Who they are: Two or more individuals who take a loan together.
- Key Consideration: All borrowers are jointly and severally liable for the loan. This means the bank can recover the entire amount from any one of the borrowers if the others fail to pay.
- Example: A husband and wife taking a joint home loan.
d) Married Women
- Key Consideration: A married woman has the full contractual capacity to borrow money. Her husband is not liable for her personal debts unless he has given a guarantee.
2. Non-Individual Borrowers
These are legal or artificial entities that can borrow money in their own name.
a) Sole Proprietorship
- What it is: A business owned and run by a single person. The owner and the business are legally the same.
- Key Consideration: The personal assets of the proprietor are also liable for the business’s debts. The loan is given in the name of the proprietor.
- Example: A local grocery store owned by a single person.
b) Partnership Firm
- What it is: A business owned by two or more partners.
- Key Consideration:
- The banker must verify the Partnership Deed.
- All partners are jointly and severally liable for the firm’s debts.
- Any partner can bind the firm by their actions.
c) Hindu Undivided Family (HUF)
- What it is: A family business entity unique to Hindus in India.
- Key Consideration:
- The family is managed by the senior-most male member, called the Karta.
- The Karta has the authority to borrow for the family business.
- The liability of the Karta is unlimited, while the liability of other members (coparceners) is limited to their share in the family property.
d) Limited Companies
- What it is: A legal entity separate from its owners (shareholders). The liability of the shareholders is limited to their investment.
- Key Consideration:
- The banker must verify the Memorandum of Association (MOA) and Articles of Association (AOA) to check the company’s power to borrow.
- A Board Resolution authorizing the borrowing must be obtained.
- Types:
- Private Limited Company: Has 2 to 200 members.
- Public Limited Company: Can have an unlimited number of members and can list its shares on a stock exchange.
e) Trusts
- What it is: An arrangement where a property is managed by one person (the Trustee) for the benefit of another (the Beneficiary).
- Key Consideration: The banker must carefully examine the Trust Deed to verify the trustee’s power to borrow on behalf of the trust.
Summary
A banker must deal with different types of borrowers, each having a distinct legal status. For individual borrowers, the key considerations are age and mental capacity. For non-individual borrowers, it is crucial to verify the legal documents that govern their existence and their power to borrow, such as the Partnership Deed for a firm or the MOA and AOA for a company. Proper documentation ensures that the loan is legally valid and enforceable.
Quick Revision Points
- Minor: A contract with a minor is void. Banks cannot lend to minors.
- Joint Borrowers: Are jointly and severally liable.
- Sole Proprietor: The owner and business are the same; liability is unlimited.
- Partnership: Check the Partnership Deed. All partners have unlimited liability.
- HUF: The Karta has borrowing powers. Karta’s liability is unlimited.
- Limited Company: A separate legal entity. Check MOA, AOA, and Board Resolution. Liability is limited.
- Trust: Check the Trust Deed for borrowing powers.
Credit Facilities are the different types of loans and advances that banks offer to their customers. Understanding each type is essential as they are designed for different purposes and have different features.
Main Categories of Credit Facilities
All credit facilities can be broadly divided into two main categories:
- Fund-Based Facilities: Where the bank’s own money is immediately involved.
- Non-Fund-Based Facilities: Where the bank does not lend its money directly but provides a guarantee on behalf of the customer.
1. Fund-Based Facilities
In these facilities, there is a direct outflow of money from the bank to the borrower.
a) Term Loan
- What it is: A loan given for a fixed period (term) of more than one year. It is repaid in regular installments, known as Equated Monthly Installments (EMIs).
- Purpose: To finance the purchase of long-term assets like machinery, a house, or a car.
- Example: A Home Loan of ₹50 lakhs for 20 years or a Car Loan of ₹8 lakhs for 5 years are classic examples of term loans.
b) Cash Credit (CC)
- What it is: A running account facility where a borrower can withdraw funds from the account up to a sanctioned limit. It is like a current account with a chequebook, but the borrower can overdraw from it.
- Purpose: To finance the working capital needs of a business (e.g., buying raw materials, paying salaries).
- Key Feature: Interest is charged only on the amount actually utilized and for the period it is used, not on the entire sanctioned limit.
- Example: A small business has a CC limit of ₹10 lakhs. It withdraws ₹3 lakhs to buy raw materials. The interest will be charged only on the ₹3 lakhs.
c) Overdraft (OD)
- What it is: A facility that allows a customer to withdraw more money from their current account than the actual balance.
- Purpose: To meet temporary, short-term funding gaps.
- Key Difference from Cash Credit: An OD is usually for a very short period and is often granted against the security of financial assets like Fixed Deposits or shares. A CC is a more formal arrangement for business working capital.
- Example: A customer with ₹20,000 in their current account needs to make an urgent payment of ₹25,000. If they have an OD facility, the bank will allow the payment, and their account balance will show a negative or debit balance of ₹5,000.
d) Bill Discounting
- What it is: A facility where a bank buys a bill of exchange from a seller before its due date and pays the seller the amount immediately, after deducting a small fee (the discount).
- Purpose: To provide immediate cash to a seller who has sold goods on credit.
- Example: A seller sells goods worth ₹1 lakh to a buyer on 60-day credit and draws a bill. The seller can take this bill to the bank and get immediate cash (e.g., ₹98,000). The bank will then collect the full ₹1 lakh from the buyer on the due date.
2. Non-Fund-Based Facilities
In these facilities, the bank does not pay out any funds immediately. Instead, it provides an undertaking or a guarantee. The bank’s funds are only used if the customer defaults on their commitment.
a) Letter of Credit (LC)
- What it is: A written undertaking given by a bank (issuing bank) on behalf of its customer (the buyer/importer) to the seller/exporter. The bank guarantees that it will make the payment to the seller, provided the seller complies with the terms and conditions mentioned in the LC.
- Purpose: To facilitate international trade by providing payment security.
- Example: An Indian importer wants to buy goods from a US exporter. The US exporter is worried about payment. The Indian importer’s bank issues an LC, which is a guarantee to the exporter that they will be paid once they ship the goods and present the required documents.
b) Bank Guarantee (BG)
- What it is: A promise from a bank that if its customer fails to fulfill a contractual obligation, the bank will pay a specified amount of money to the beneficiary.
- Purpose: To provide security for performance in contracts, especially in infrastructure projects and tenders.
- Example: A construction company wins a contract to build a road. The government department asks for a Performance Bank Guarantee. The company’s bank issues a BG, promising to pay the government a certain amount if the construction company fails to complete the road as per the contract.
Summary
Credit facilities are the various ways banks provide financial support. Fund-based facilities involve the direct lending of money, with Term Loans used for long-term assets and Cash Credit/Overdraft for short-term working capital. Non-fund-based facilities like Letters of Credit and Bank Guarantees do not involve an immediate cash outflow but see the bank providing a promise or guarantee, which is crucial for facilitating trade and contracts.
Quick Revision Points
- Fund-Based: Involves an actual outflow of bank funds. (e.g., Term Loan, Cash Credit).
- Non-Fund-Based: Involves no immediate outflow of funds; it’s a promise. (e.g., LC, BG).
- Term Loan: For long-term assets; repaid in EMIs.
- Cash Credit (CC): For working capital; interest is on the utilized amount.
- Overdraft (OD): For temporary funding gaps.
- Letter of Credit (LC): Used for guaranteeing payment in international trade.
- Bank Guarantee (BG): Used for guaranteeing performance in a contract.