PRINCIPLES OF LENDING

Loan Process Flowchart

 Banks follow the following principles of lending:

1. 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they lend public money which can be withdrawn at any time by depositors.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.

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.

2. Safety:
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, 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.

3. Diversity:
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 minimising 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. 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.
4. Stability:
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.

5. Profitability:
This is the cardinal principle for making investment by a bank. It 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 centre, 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.

Some other important points:
The principles of lending revolve mainly around the concepts of safety, profitability and
liquidity of advance. The criteria for lending get changed or modified from time to time in
response to changing the state of the economy. Traditionally commercial banks in India used
to provide security oriented finance to trade and industry. Big industrial houses and traders
were beneficiaries of security oriented lending concept and a large chunk of bank finance was
enjoyed by them. The concept of lending radically changed in 1969 after the nationalisation of
fourteen commercial banks. The concept of security based bank finance changed to the concept
of need based finance, albeit wherever collateral securities are available continued to be
accepted. Thus the focus is on the viability of project while entertaining the credit proposals
and not merely on the availability of security. However basic principles that govern bank
lending remain unchanged on safety, profitability and liquidity of advance. The banks all over
the world scrutinise following details with care before acceding to a loan request.
Identification of borrower: Selection of a borrower is a most important factor to be considered
at care. There are numerous instances of parties indulge in various types of frauds and forgeries
to cheat banks and avail finance. Banks can avoid most of such instances by sticking to
principles of KYC (Know Your Customer) in letter and spirit. While entertaining new
proposals, as a matter of rule and without fail, caution advice and defaulter list of RBI/ECGC
caution list/CIBIL Report/Reports from other banks must be verified. Trade circle enquiry,
information from Newspapers and magazines may sometimes supply important information
which is a matter of concern to the bank. Since the safety of funds lent will be the main concern
of a bank, the advance should be granted to a reliable borrower who can repay the loan in the
ordinary course of business.
The Purpose of loan: The proposal may be for a new venture or for expansion or
diversification of existing unit or for a renewal/ revival/ enhancement of existing limits.
Though the request for advance may be safe and secured, still bank should concentrate whether
the advance is for productive purpose and it is needed for legitimate activity from the standpoint
of Government guidelines.
Quantum of Loan: A prudent banker ensures that finance made available to the borrower is
neither over financed nor under financed. Inadequate finance kills the project and thereby sinks
the bank finance. Over finance enables the borrower to divert the funds for the activities other
than the purpose he had availed the facility, which ultimately jeopardises the repayment plan.
Hence proper appraisal is a must before sanctioning a quantum of loan or credit limit.
Period of Loan: A Bank would remain liquid if its advances are also liquid. A type of loan and
maturity pattern bank entertains is essential for its asset liability management. The repayment
period (short/long term) fixed on loans shall be adequate to match the demand of depositors.
Source of repayment: The repayment of advance is of paramount importance to a bank. When
a borrower approaches the bank for finance, he must have a clear idea of how he is repaying
the loan/advance and indicate the same to the bank. The source of repayment may be from
income generated out of business/salary or any other source. In the cases of working capital
account like Cash Credit or bills purchase/discount facilities, it may be self-liquidating on the
realisation of sale proceeds.
Security for advance: The type of security offered to the bank is an important criterion while
entertaining a loan proposal. The prime security can be hypothecation/pledge of stock, book
debts or other assets created out of bank finance. Bank may insist for a charge on immovable
property as a collateral security in addition to prime security and a third party guarantee (which
is also treated as security to bank finance). The main concern is that security available to the
bank should be good enough to fall back upon in the event of adverse circumstances. The value
of security accepted should be steady and easy to ascertain. All precaution to be taken while
accepting the immovable property as security that the security offered has a clear marketable
title. It is also inevitable to ascertain and confirm through legal opinion from an experienced
advocate so that bank could easily take possession of such security with very little expenses
and dispose-off the same to recover its dues when the account goes bad.
Profitability: Credit risk is always associated with any type of lending Interest rate charged to
an advance must be commensurate with risk entailed, the amount of work and also expenses
involved in the facility.
Pre-Sanction Inspection:
Branch Manager should visit the borrower at his place of business and make the preliminary
report on prime/collateral security offered. The purpose is to see that the business exists at the
address given. It is also useful to ascertain the infrastructure available and level of activity of
the unit. Further, it helps the Manager to familiarise himself the borrower’s business and
attendant trade practices.
Appraisal of credit proposal:
Poor quality of credit appraisal both technical and financial viability, contribute to the accretion
of Non-Performing Assets (NPA). Accepting unrealistic projection and fixing unduly short
repayment schedule may cause problems at the time of recovery. The credit officer would
consider all the information collected from internal and external investigation sources to
support the credit decision. Promoter’s educational, professional qualification, experience,
management capability, history of payment record and fulfilment of financial obligations etc,
are the matter of importance while appraising the proposals. The general documents, apart from
the exclusive set of financial papers which depends upon nature of finance, required by banks
are as under.
In conclusion, appraisal of credit proposal can be called as the assessment of the Techno-
economic feasibility of the business and also satisfying ‘Three C’s of the borrower i.e. the
Character of the borrower, Capital/margin brought by the borrower and his Capacity to run the
business. The appraisal should also be free from Complacency, Carelessness, Communication
gap and unhealthy Competition.
Sanction: The essence of a sanction is adequate credit given to a borrower in time. Bankers
should be sensitive to the difficulties of the borrower. Many a time, we hear that Credit
officers/Managers do not exhibit the sense of urgency while considering the borrower’s
request. Although it is necessary to function within broad framework provided by the bank for
credit assessment and disbursement, the sanction should not be delayed under the guise of rules
and regulations.
Documentation: The execution of documents according to the law in the proper form is called
documentation. Documentation is the most important part of a bank lending. The role of
documentation is to establish a legal relationship between the lending banker and borrower
when the dispute goes to the court of law. The official in charge must be thoroughly conversant
with the type of securities and legal nature of charges to be created while preparing the
documents.
Stamping: Under section 17 of Indian Stamp Act 1899, all the documents chargeable with
stamp duty shall be properly and duly stamped before or at the time of execution in India. In
the cases of Demand Promissory Note (pro-note), acknowledgement of debts, bill of exchange
etc, if under stamped, is ab-initio void and same cannot be admitted in evidence even by paying
penalty. The revenue stamps on the document should be effectively cancelled at the time of
execution. The best way of cancellation of revenue stamp is by the sign over all the stamps in
such a manner that signature extends even beyond the stamps.
Execution: The document should be executed in the presence of Manager/Authorised official
of the bank. The documents should not be given to borrower for obtaining signature/s from
other borrowers or guarantors. The documents should be executed in one sitting and also ensure
that the executants read the content of documents prior to execution. The borrower should sign
in full on all the documents and not by initials. The cutting, overwriting, interlineations must
be authenticated under the full signature of the executants/s. Any instrument chargeable with
stamp duty executed out of India must be stamped within 3 months after it has been first
received in India.
Attestation: Attestation means witnessing the execution of a document which is required to be
attested under law. In the case of documents like the assignment of LIC policies one witness is
required and in the case of mortgage deed there should be two witnesses. Some documents like
demand promissory note need not be attested. The executants are the party to the deed and they
should not be attesting persons. The attesting person need not know the contents of the
document.
Registration of Mortgage/Memorandum of mortgage: In the case of mortgage deed or
memorandum of title deeds to be registered the original deed must be presented for registration
with Registrar of Assurance (Commonly known as Sub-Registrar office) under whose
jurisdiction property is situated. The registration should be done within four months of
execution of documents.
Registration with Registrar of Companies (ROC): In the case of limited companies, charge on
company’s assets like hypothecation of stocks and machinery, book debts, mortgages etc shall
be recorded with ROC within 30 days of execution of documents in terms of Sec.125 of the
companies Act. The registration should be done with the Registrar of Companies under whose
jurisdiction the company’s Registered Office is situated.
Post disbursement follow up: Direct payment shall be made towards goods/machinery
purchased as per invoice made by way of demand draft in favour of the supplier. It is wrong to
credit the loan proceeds to borrower’s SB/CD account, as it is observed that many a time bank
finance was diverted by the borrower for the purpose other than loan was actually sanctioned.
The inspection shall be conducted for the purpose of ascertaining end use/creation of assets
from bank finance. Care shall be taken by the inspecting official that old/defunct machinery
are not shown to him as new machinery. Bank’s board of hypothecation/pledge shall be
prominently displayed where the stocks/machinery are placed. The working capital limits
sanctioned, are usually valid for one year, hence proposals for ‘Renewal /Enhancement of
limits’ should be taken up well in time. The documents obtained while releasing the limits shall
be properly maintained, revival letters, acknowledgement of debts etc. to be obtained at the
periodical interval, to keep the documents alive. Asset created by bank finance shall be fully
insured with bank clause. In some cases, the company holds inventory over and above the
working capital limit and go for insurance only to the extent of credit limits. Banks shall not
accept such proposal of the borrower, as it amounts to under insurance. In such an event of
under insurance, the insurance company will settle proportionately to the extent of total stock
holding vis-à-vis insurance cover although damage claimed is within the insurance cover
amount. In view of avoiding claim complications banks normally insist for comprehensive
insurance for not less than 120% of the inventory holding.