“Principle of Good lending”

The final draft submitted on fulfillment of the course, banking law during the academic
session 2020-2021, Semester-VIII.

Submitted by

Name: Mukul Rathore

Roll No.: 1742

Class: BA LL.B. (H), 8th semester.

Submitted to

Mr. Abhishek Kumar (Assistant professor of law)

APRIL 2021

CHANAKYA NATIONAL LAW UNIVERSITY, NYAYA NAGAR, MITHAPUR,

PATNA- 800001.

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 ACKNOWLEDGEMENT

I would like to thank my faculty Mr. Abhishek Kumar, sir whose assignment of such a relevant
topic made me work towards knowing the subject with a greater interest and enthusiasm and
moreover he guided me throughout the project.

I owe the present accomplishment of my project to my friends, who helped me immensely with
sources of research materials throughout the project and without whom I couldn’t have
completed it in the present way.

I would also like to extend my gratitude to my parents and all those unseen hands who helped
me out at every stage of my project.

THANK YOU!
MUKUL RATHORE
1742

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 DECLARATION

I hereby declare that the work reported in the B.A.LLB (Hons.) Project Report entitled “Principle of

Good lending” submitted at CHANAKYA NATIONAL LAW UNIVERSITY, PATNA is an

authentic record of my work carried under the supervision of Mr. Abhishek Kumar, sir. I have not

submitted this work elsewhere for any other degree or diploma. I am fully responsible for the contents

of my project report.

MUKUL RATHORE

CHANAKYA NATIONAL LAW UNIVERSITY, PATNA

08/04/2021

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 TABLE OF CONTENT

CH 1- INTRODUCTION .......................................................................................................... 8

CH 2- RESEARCH METHODOLOGY… ..............................................................................8

CH 3- PRINCIPLE OF LIQUIDITY ......................................................................................... 9

CH 4- PRINCIPLE OF SAFETY ............................................................................................ 10

CH 5- PRINCIPLE OF DIVERSITY, STABILITY & PROFITABILITY ............................. 12

CONCLUSION & SUGGESTIONS ....................................................................................... 14

BIBLIOGRAPHY .................................................................................................................... 15

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 CH 1- INTRODUCTION

Bank performs different functions. Lending of money to different kinds of borrowers is one of
the most important functions of commercial bank. A major portion of its fund is used for this
purpose and this is also the major sources of bank’s income. However, lending is not without
risk. The borrowers of a bank range from individuals to partnership, companies, institutions,
societies etc. The nature of their activities, the location of business, financial stability, earning
and repaying capacity, purpose of advance, securities all differ and their degree of risks also
differ. Therefore, a banker must take proper precaution in this process. Some of the important
considerations to be kept in mind by a banker in this respect are discussed below.1

Safety: Safety means that the borrower should be able to repay the loan and interest in time at
regular intervals without default. Banks are trustee of public money. Bank’s deposits are always
payable on demand. Bank has to maintain trust of depositor forever. As such the first and
foremost principle of lending is to ensure safety of funds lent. Further, it is just not the capacity
of the borrower to repay but also his willingness to repay. The former depends on his tangible
assets and the success of his business. The latter depends on the borrower’s character. Liquidity:
The term liquidity refers to the extent of availability of funds with the banker for providing
credit to borrowers. It is to be seen that money lent is not going to be locked up for a long time.
The money should return to the bank as per the repayment schedule. This schedule that is drawn
up by the banker has to adhere to the requirement that at any point of time the banker should
possess liquidity to meet the withdrawals of the depositors. It is to be kept in mind that various
deposits have various maturities and some of it would also be payable on demand. A bank’s
inability to meet the demand of its depositors can lead to a run on the bank which is a threat to
its basic survival. Hence the banker has to always monitor the cash flows and carry out the
exercise of ensuring liquidity with the borrower as this in turn means liquidity with the banker.
Further, liquidity would also refer to the quality of assets, which should be easily convertible
into cash without any loss of value.

1
Important Principle of good lending, http://www.yourarticlelibrary.com/banking/5-important-principles-
followed-by-the-banks-for-lending-money/11007 Last visited on 29/02/20.

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Thus, the concept of liquidity entails the banker to look for easy salability and absence of risk
of loss on sale of asset, which has been taken as collateral.2
Purpose: The purpose should be productive so that the money not only remain safe but also
provides a definite source of repayment. Loans may be required for productive purposes,
trading purposes, agriculture, transport, self-employment etc. If a loan is required for a non-
productive or speculative purpose, the banker should be very much cautious in entertaining
such proposals. It is very difficult to ensure that the loan has been utilized for the purpose for
which it was sanctioned. Banker should take follow-up measures to ensure end use of fund
exactly for the same purpose for which it is borrowed. Profitability: Banks are not charitable
institutions. All banks are profit-earning institutions. The ultimate objective of lending is to
earn profits. Banks receive interest on loans and advances lent, and they pay interest to their
depositors.

This difference between the receipts and payments will be the bank’s gross profit. Banks further
incur various expenses as any organization does. After accounting for all such expenses and
provisions, banks have to earn reasonable amount as net profit (NIM) so that dividends can be
paid to its shareholders. The trust and confidence level of the customer and investor will be
high with a bank that has a good track record of profits and dividend rates. Hence it is important
that whatever the business the bank engages itself with, the business be profitable enough not
just to cover its costs but to ensure generation of surplus funds or margin. It is prudent for the
banker to consider overall profitability of the entire business that is undertaken rather than the
profitability against each component of business or service offered. Security: The security
offered by a borrower for an advance is as like as the insurance to the banker. It serves as the
safety valve for an unforeseen emergency. So another principle of sound lending is the security
of lending. Security offered against loan may be various. It may be a plot of land, building, flat,
insurance policies; term deposits etc. There may even be cases where there is no security at all.
The banker must realize that is it only a cushion to fall back upon in case of need. The security
and its adequacy alone should not form the sole consideration for judging the viability of a loan
proposal. Nevertheless, the security if accepted must be adequate and readily marketable, easy
to handle and free from encumbrance. It is the duty of the banker to check the nature of the
security and assess whether it is adequate for the loan granted. Diversification: A prudent

2
Good Banking, https://neweconomics.org/2011/07/good-banking Last visited on 29/02/20.
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 banker always tries to select the borrower very carefully and takes tangible assets as security
to safeguard his interests. While this is no doubt an adequate measure, there are other
unforeseen contingencies against which the banker has to guard himself. Further if the bank
lends large amounts to a single industry or borrower, then the default by that customer can
affect the banking industry as a whole and will affect the basic survival of the industry. To
safeguard his interest against all such risks, the banker follows the principle of diversification
of risks based on the famous maxim ‘never keep all the eggs in one basket’. By lending funds
to different sectors, a bank can save itself from the slump in some sectors by way of prosperity
in the others. Banks have to lend to a large number of industries and borrowers so that the risk
gets diversified National Interest: Even when an advance satisfies all the aforesaid principles, it
may still not be suitable. The advance may run counter to national interest. Bank has a significant
role in the economic development process of a country. They should keep in mind the national
development plan/program while going for lending but maintaining safety, liquidity and
profitability.3

3
Supra note 1.
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 CH 2- RESEARCH METHODOLOGY

This project is based upon doctrinal method of research.

• Sources of Data:
The following secondary sources of data have been used in the project-
1. Articles.
2. Books

• Method of Writing:
The method of writing followed in the course of this research project is primarily analytical.
• Mode of Citation:
The researchers have followed a uniform mode of citation throughout the course of this project.
• Aims and Objectives
The researcher intends to find out the following- to find out the principles which commercial
bank should follow while lending.
Research question
1. What is principle of liquidity?
2. What is principle of safety?
3. What are Other principles of good lending?
• Hypothesis
The researcher has formulated the hypothesis that - there should be stronger regulations for
Ensuring that banks Follow important principles Of Lending.

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 CH 3- PRINCIPLE OF LIQUIDITY

Liquidity is an important principle of bank lending. Bank lend for short periods only because
they lend public money which can be withdrawn at any time by depositors. They, therefore,
advance loans on the security of such assets which are easily marketable and convertible into
cash at a short notice.

It is not enough that the money will come back; it is also necessary that it must come back on
demand or in accordance with agreed terms of repayment. The borrower must be in a position
to repay within a reasonable time after a demand for repayment is made. This can be possible
only if the money is employed by the borrower for short-term requirements and not locked up
in acquiring fixed assets, or in schemes which take a long time to pay their way. The source of
repayment must also be definite. The reason why bankers attach as much importance to
'liquidity' as to safety' of their funds, is that a bulk of their deposits is repayable on demand or
at short notice. If the banker lends a large portion of his funds to borrowers from whom
repayment would be coming in but slowly, the ability of the banker to meet the demands made
on him would be seriously affected in spite of the safety of the advances. For example, an
advance of Rs.50 lakhs (approx. $111,354.60USD) on the security of a legal mortgage of a
bungalow of the market value of Rs. 100 lakhs (approx. $222,716.82 USD), will be very safe.
If, however, the recovery of the mortgage money has to be made through a court process, it
may take a few years to do so. The loan is safe but not liquid. Liquidity is an important principle
of bank lending. Bank lend for short periods only because they lend public money which can
be withdrawn at any time by depositors. They, therefore, advance loans on the security of such
assets which are easily marketable and convertible into cash at a short notice. A bank chooses
such securities in its investment portfolio which possess sufficient liquidity. It is essential
because if the bank needs cash to meet the urgent requirements of its customers, it should be in
a position to sell some of the securities at a very short notice without disturbing their market
prices much. There are certain securities such as central, state and local government bonds
which are easily saleable without affecting their market prices. The shares and debentures of
large industrial concerns also fall in this category. But the shares and debentures of ordinary
firms are not easily marketable without bringing down their market prices. So, the banks should
make investments in government securities and shares and debentures of reputed industrial
houses.
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 CH 4- PRINCIPLE OF SAFETY

"Safety first" is the most important principle of good lending. When a banker lends, he must
feel certain that the advance is safe; that is, the money will definitely come back. If, for
example, the borrower invests the money in an unproductive or speculative venture, or if the
borrower himself is dishonest, the advance would be in jeopardy.4Similarly, if the borrower
suffers losses in his business due to his incompetence, the recovery of the money may become
difficult. The banker ensures that the money advanced by him goes to the right type of borrower
and is utilized in such a way that it will not only be safe at the time of lending but will remain
so throughout, and after serving a useful purpose in the trade or industry where it is employed,
is repaid with interest. The safety of funds lent is another principle of lending. Safety means
that the borrower should be able to repay the loan and interest in time at regular intervals
without default. The repayment of the loan depends upon the nature of security, the character
of the borrower, his capacity to repay and his financial standing. Like other investments, bank
investments involve risk. But the degree of risk varies with the type of security. Securities of
the central government are safer than those of the state governments and local bodies. And the
securities of state government and local bodies are safer than those of the industrial concerns.
This is because the resources of the central government are much higher than the state and local
governments and of the latter higher than the industrial concerns. In fact, the share and
debentures of industrial concerns are tied to their earnings which may fluctuate with the
business activity in the country. The bank should also take into consideration the debt repaying
ability of the governments while investing in their securities. Political stability and peace and
security are the prerequisites for this. It is very safe to invest in the securities of a government
having large tax revenue and high borrowing capacity. The same is the case with the securities
of a rich municipality or local body and state government of a prosperous region. So, in making
investments the bank should choose securities, shares and debentures of such governments,

4
Basic principles that Commercial bank follow, https://iedunote.com/principles-commercial-bank Last visited on
29/02/20.
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 local bodies and industrial concerns which satisfy the principle of safety. Thus, from the bank’s
viewpoint, the nature of security is the most important consideration while giving a loan. Even
then, it has to take into consideration the creditworthiness of the borrower which is governed
by his character, capacity to repay, and his financial standing. Above all, the safety of bank
funds depends upon the technical feasibility and economic viability of the project for which the
loan is advanced.5

5
Important principles of lending, http://allbankingalerts.com/important-principles-of-lending-in-banking- principles-
of-credit/ Last visited on 29/02/20.
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 CH 5- PRINCIPLE OF DIVERSITY, STABILITY & PROFITABILITY

In choosing its investment portfolio, a commercial bank should follow the principle of
diversity. It should not invest its surplus funds in a particular type of security but in different
types of securities. It should choose the shares and debentures of different types of industries
situated in different regions of the country. The same principle should be followed in the case
of state governments and local bodies. Diversification aims at minimizing risk of the investment
portfolio of a bank. The principle of diversity also applies to the advancing of loans to varied
types of firms, industries, businesses and trades.6 A bank should follow the maxim: “Do not
keep all eggs in one basket.” It should spread it risks by giving loans to various trades and
industries in different parts of the country. Another important principle of a bank’s investment
policy should be to invest in those stocks and securities which possess a high degree of stability
in their prices. The bank cannot afford any loss on the value of its securities. It should, therefore,
invest it funds in the shares of reputed companies where the possibility of decline in their prices
is remote. Government bonds and debentures of companies carry fixed rates of interest. Their
value changes with changes in the market rate of interest. But the bank is forced to liquidate a
portion of them to meet its requirements of cash in cash of financial crisis. Otherwise, they run
to their full term of 10 years or more and changes in the market rate of interest do not affect
them much. Thus bank investments in debentures and bonds are more stable than in the shares
of companies. This is the cardinal principle for making investment by a bank.7It must earn
sufficient profits. It should, therefore, invest in such securities which was sure a fair and stable
return on the funds invested. The earning capacity of securities and shares depends upon the
interest rate and the dividend rate and the tax benefits they carry. It is largely the government
securities of the center, state and local bodies that largely carry the exemption of their interest
from taxes. The bank should invest more in such securities rather than in the shares of new
companies which also carry tax exemption. This is because shares of new companies are not
safe investments. The purpose should be productive so that the money not only remain safe
but also provides a definite source of repayment. The purpose should also be short termed so

6
Ibid
7
Important principles of commercial banking, https://www.toppr.com/guides/fundamentals-of-economics-
cma/banking/principles-of-commercial-bank/ Last visited on 29/02/20.

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 that it ensures liquidity.

Banks discourage advances for hoarding stocks or for speculative activities. There are obvious
risks involved therein apart from the anti-social nature of such transactions.8 The banker must
closely scrutinize the purpose for which the money is required, and ensure, as far as he can,
that the money borrowed for a particular purpose is applied by the borrower accordingly.
Purpose has assumed a special significance in the present-day concept. Another important
principle of good lending is the diversification of advances. An element of risk is always present
in every advance, however secure it might appear to be. In fact, the entire banking business is
one of taking calculated risks and a successful hanker is an expert in assessing such risks. He is
keen on spreading the risks involved in lending, over a large number of borrowers, over a large
number of industries and areas, and over different types of securities9.For example, if he has
advanced too large a proportion of his funds against only one type of security, he will run a big
risk if that class of security steeply depreciates. If the bank has numerous branches spread over
the country, it gets a wide assortment of securities against the advances. Slump does not
normally affect all industries and business centers simultaneously. Even when an advance
satisfies all the aforesaid principles, it may still not be suitable. The advance may run counter
to national interest. The Federal / Central Bank (e.g., Reserve Bank of India, RBI) may have
issued a directive prohibiting banks to allow the particular type of advance. The law-and-order
situation at the place where the borrower carries on his business may not be satisfactory. There
may be other reasons of a like nature for which it may not be suitable for the bank to grant the
advance. In the changing concept of banking, factors such as purpose of the advance, viability
of the proposal and national interest are assuming a greater importance than security, especially
in advances to agriculture, small industries, small borrowers, and export-oriented industries.10

8
Supra note 1.
9
Supra note 7.
10
Banking Principle, https://bank4study.blogspot.com/2015/02/banking-principles-of-sound-
lending.html?m=1Last visited on 29/02/20.
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 CONCLUSION & SUGGESTIONS

Depositors keep money with banks in good faith. If a banker is unable to honor their claims of
withdrawals, the whole banking business becomes redundant. It is a fundamental precept of
banking everywhere that advances are made to customers in reliance on his promise to repay,
rather than the security held by the banker. Although all lending involves some degree of risks,
it is necessary for any bank to develop sound and safe lending policies and new lending
techniques in order to keep the risk to a minimum. As such, the banks are required to follow
certain principles of sound lending. Banks follow some fundamental principles of lending in
order to ensure safety, security and profitability on money it lend.

(a) Safety: Advances should be expected to come back in the normal course. The repayment of
the loan depends upon the borrower’s capacity to pay and willingness to pay. The capacity
depends upon the tangible assets of the borrower. The willingness to pay depends upon the
honesty and character of the borrower.

(b) Liquidity: Liquidity is the availability of bank funds on short notice. The borrower must be
in a position to repay within a reasonable time. Liquidity also signifies that the assets should
be scalable without any loss.

(c) Profitability: A banker has to see those major portions of the assets owned by it are not only
liquid but also aim at earning a good profit. The difference between the interest received on
advances and the interest paid on deposits constitutes a major portion of bank’s income.
Besides, foreign exchange business is also highly remunerative.

(d) Purpose: A banker would not throw away money for any purpose for which the borrower
wants. The purpose should be productive so that the money not only remains safe but also
provides a definite source repayment.

(e) Security: Security serves as a safety valve for an unexpected emergency. The security
offered for an advance is a cushion to fall back upon in case of need. An element of risk is
always present in every advance however secured it might appear to be.

(f) Spread/ Diversity: The advances should be as much broad-based as possible and must be in
keeping with the deposit structure. The advances must not be in one particular direction or to
one particular industry. Again, advances must not be granted in one area.

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 BIBLIOGRAPHY

BOOKS

1. Vasudevan, S.V., "A Text Book of Banking Law and Practice and Theory_ of
Banking", S. Chand & Company (Pvt) Limited, New Delhi, 2006
2. Saxena, R.M. "Development Banking in India", Vora & Co., Bombay,2009
3. Sayers, R.S. "Modern Banking", Oxford University Press, New Delhi, 1999

WEBSITE

1. https://www.google.com/url?q=http://www.yourarticlelibrary.com/banking/5-

important-principles-followed-by-the-banks-for-lending-

money/11007&sa=U&ved=2ahUKEwja9JqqvIDoAhUVzDgGHXTPCWcQFjALegQ

IBhAB&usg=AOvVaw3UDnJSCxMWks9jbsy-Ads2

2. https://www.google.com/url?q=https://kalyan-city.blogspot.com/2010/09/principles-

of-good-lending-every-

banker.html%3Fm%3D1&sa=U&ved=2ahUKEwja9JqqvIDoAhUVzDgGHXTPCWc

QFjAMegQIBxAB&usg=AOvVaw0DKBHQSOwQ6ZHdU9XltE3F

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