Chapter - 14

LOANS AND ADVANCES

By
Abdullah Al Masud
Lecturer
Southeast Business School
Southeast University

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 INTRODUCTION

• One of the primary functions of a bank is to

grant loans.
• Whatever money the bank receives by way of
deposits, it lends a major part of it to its
customers by way of loans, advances, cash
credit and overdraft.
• Interest received on such loans and advances
is the major source of its income.

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General Rules of Sound Lending

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 General Rules of Sound Lending
1. Safety: The most important golden rule for granting
loans is the safety of funds. For example, if a
reputed credit-worthy businessman offers to pay
10% interest per annum and on the other hand a
pauper offers 15% rate of interest per annum.
Obviously as per safety rule, the banker should not
grant loan to the pauper although paying 5% higher
rate of interest.
2. Liquidity: The second important golden rule of
granting loan is liquidity. Liquidity means
possibility of converting loans into cash without loss
of time and money.
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 General Rules of Sound Lending
3. Return or Profitability: The funds of the bank should
be invested to earn highest return, so that it may pay a
reasonable rate of interest to its customers on their
deposits, reasonably good salaries to its employees
and a good return to its shareholders. However, a
bank should not sacrifice either safety or liquidity to
earn a high rate of interest.

4. Diversification: ‘One should not put all his eggs in

one basket’ is an old proverb which very clearly
explains this principle. A bank should not invest all
its funds in one industry. Rather it should invest in
different industries.

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 General Rules of Sound Lending
5.Object of Loan: A banker should thoroughly examine
the object for which his client is taking loans. This
will enable the bank to assess the safety and liquidity
of its investment.
6. Security: A banker should grant secured loans only.
In case the borrower fails to return the loan, the
banker may recover his loan after realizing the
security.
7. Margin Money: In case of secured loans, the bank
should carefully examine and value the security.
There should be sufficient margin between the
amount of loan and the value of the security. If
adequate margin is not maintained, the loan might
become unsecured in case the borrower fails to pay
the interest and return the loan.
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 General Rules of Sound Lending
8.National Interest: Banks were nationalized in
Bangladesh to have social control over them.
As such, they are required to invest a certain
percentage of loans and advances in priority
sectors viz., agriculture, small scale and tiny
sector, and export-oriented industries etc.

9.Character of the Borrower: Last but not the

least, the bank should carefully examine the
character of the borrower. Character implies
honesty, integrity, creditworthiness and
capacity of the borrower to return the loan.
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 Forms of Lending (Advances)
Banks lend for working capital requirements in
the form of:

1. Loans
2. Cash credit
3. Overdraft
4. Purchase and discounting of bills of
exchange.

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 Loans
▪ This is the oldest and very popular form of
lending by the banks.
▪ In case of loans, financial assistance is given
for a specific purpose and for a fixed period.
▪ The customer can withdraw the entire amount
of loan in a single installment.
▪ As such, interest is payable on the entire
amount.

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 Loans
Merits of Granting Loans:

❑Simplicity
❑Better Recovery of Interest and Loa
❑Profitability

Demerits:
❑Inflexibility
❑Over borrowing
❑More Formalities

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 Cash Credit
▪ Cash credit is the most popular method of lending
by the banks in Bangladesh.
▪ Under cash credit system, a limit, called the credit
limit is specified by the bank.
▪ A borrower is entitled to borrow up to that limit.
▪ It is granted against the security of tangible assets
or guarantee.
▪ The borrower can withdraw money, any number
of times up to that limit.
▪ He can also deposit any amount of surplus funds
with him from time to time.
▪ He is charged interest on the actual amount
withdrawn and for the period such amount is
▪
drawn. 11
 Commitment Charges
▪ To discourage the borrower from keeping large
funds idle within the sanctioned limit bank
levies commitment charges.

▪ This also helps the bank in two ways.

Firstly, it compensates him for the loss on idle

funds kept by him within the credit limit
sanctioned.
Secondly, it facilitates better credit funds
management.
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 Cash Credit
Merits of Cash Credit:

❑ Flexibility
❑ Economical
❑ Less Formalities

Demerits:
❑ Over Borrowing
❑ Division of Funds
❑ Non-utilization of Funds
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 Overdraft
▪ One of the main advantages of a current
account is that, its holder can avail of the
facility of overdraft.
▪ An overdraft facility is granted to a customer
on a written request
▪ Sometimes, it may be implied where a
customer overdraws his account and the bank
honors his cheques.
▪ He should also settle the terms and conditions
and the rate of interest chargeable.
▪ It is usual to obtain a promissory note from the
customer to cover the overdraft.
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 Discounting Bills of Exchange
• Discounting of bills of exchange is another type of lending by the modern
banks. Bill Discounting is a discount/fee which a bank takes from a seller to
release funds before the credit period ends.
• Discounting of bills refers to a facility in which holder of a bill of exchange
can get the bill discounted with bank before the maturity.
• After deducting the commission, bank pays the balance to the holder. This
bill is then presented to seller's customer and full amount is collected.
• Bill Discounting is mostly applicable in scenarios when a buyer buys goods
from the seller and the payment is to be made through letter of credit.

• For example : A drawer has a bill for Rs. 10,000. He discounted this bill with
his bank two months before its due date at 15% p.a. rate of discount.
Discount will be calculated as the follow: 1,000 × 15/100 × 2/12 = 250. Thus
the drawer will receive a cash worth Rs. 9,750 and will bear a loss of $250.
The bank will keep this bill in possession till the due date. On maturity (due
date) the bank will present the bill to the acceptor and will receive cash
from him. In case, the acceptor does not make the payment to the bank,
then the drawer on any person who has discounted the bill have to take this
liability and will pay cash to the bank.

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 Distinction between Loan and Cash Credit

Amount: In case of loan a fixed amount is sanctioned,

whereas in case of cash credit a limit is fixed.

Period: Loan can be granted for a short, medium and

long-term but cash credit is granted only for a short
period up to one year only.

Withdrawal: The entire amount of loan is credited to

the customer’s account. In case of cash credit the
customer can withdraw the amount up to the limit
when he needs.
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 Distinction between Loan and Cash Credit

Interest: In case of loan, interest is payable on

the entire loan, whereas in case of cash credit,
interest is payable only on the amount actually
withdrawn and for the period the amount is
withdrawn.

Repayment: Ordinarily a loan is repayable in

one lump sum. However, it may be paid in
installments also. On the other hand in case of
cash credit, the borrower may repay any
surplus amount from time to time.
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 Distinction between Cash Credit and Overdraft
Period: The main difference between cash credit
and overdraft is that the former is granted
comparatively, for a longer period, whereas
overdraft is a temporary facility.
Opening Separate Account: For granting cash
credit it is necessary to open a new account. No
new account is necessary for overdraft.
Current Account: Overdraft facility is granted to a
current account holder only. It is not necessary to
be a current account holder, to avail of the facility
of cash credit.
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 Distinction between Cash Credit and Overdraft

Control of Central Government: The Central

Government exercises strict control over cash
credit. There is no such control on overdraft.
Commitment Charges: In case of
under-utilization of cash credit a customer has
to pay commitment charges. No commitment
charges are payable in case of overdraft.
Form of Security: Cash credit is ordinarily
granted on the security of goods by way of
pledge or hypothecation. Overdraft is granted
on the personal security of the borrower or
financial securities viz., shares, bonds etc.
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 Types of Loans and Advances
On the Basis of Object or Purpose

Commercial Loans: This loan is taken to meet

short term requirement of capital e.g., working
capital.

Consumer Loan: This loan is taken to finance

household goods like fridge, T.V., scooter etc.

Agricultural Loan: Such a loan is taken by the

farmers to meet their short term requirements
like buying seeds, fertilizers, insecticides etc.
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 Types of Loans and Advances
On the Basis of Time

Short Term Loan: Such a loan is taken for a period of

less than one year. For. example, to meet working
capital requirements.
Medium Term Loan: Such a loan is taken for a period
ranging from 1 year to 5 years. For example, to
purchase equipments for professionals or furniture etc.
Long Term Loan: Such a loan is taken to meet
long-term requirements from 5 years to 30 years or
more. For example, loans to purchase land, building,
plant and machinery etc. However, banks provide
long-term loans to a very limited extent only.

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 Types of Loans and Advances
On the Basis of Security

Secured Loan: Such a loan is granted on the

security of tangible assets, is called‘ secured
loan or advance’ as a loan or advance is made
on the security of assets, the market value of
which is not at any time less than the amount
of such loan or advance.

Unsecured Loans: Such a loan is granted

without any security. An unsecured loan or
advance means a loan or advance not so
secured.
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 Determining Creditworthiness
A banker has to be very careful while granting
loans. Even in the case of secured loans, the
banker should carefully examine the
creditworthiness of the borrower. The
following factors should be kept in mind while
determining the creditworthiness of the
borrower:

❑ Character
❑ Ability to Run the Enterprise
❑ Adequate Capital
❑ Soundness of the Project
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 Sources of Credit Information
A banker needs credit information about a
customer, his enterprise, industry etc., in order
to assess his creditworthiness. He should cross
check the information collected by him from
different sources. Credit information can be
collected from the following sources:

❑ The Borrower
❑ Credit Information Bureau (CIB)
❑ Exchange of Credit Information
❑ Enquiries From Traders and
Businessmen in the Same Trade
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