In India, or in any economy, economic development is only possible if there is an adequate

amount of capital accumulation. Any deficiency in capital accumulation hinders economic and
GDP growth. One factor stimulating economic growth is the lending of capital from net savers to
net borrowers. Banks and lenders play an important role in this flow of capital. Banks mobilise
capital in the form of deposits and provide capital to the economy in the form of credit.

This lesson provides an overview of the banking system and its role in the economy.

By the end of this lesson, you should be able to:

 Explain the relationship between bank credit and economic growth.

 Explain the nature of the banking industry.
 Describe how prudent lending is critical for the overall financial health of a bank.
 Identify the various units within the bank based on client types and their business needs.

Individuals, companies, and other business entities deposit idle cash into
banks to earn interest income. In turn, banks use these deposits to lend to
the individuals or businesses seeking capital in the economy. Banks act as
financial intermediaries by enabling the flow of capital from savers to
borrowers.

Banks offer financial assistance in the form of loan facilities to various

segments of the economy, including corporations, small and medium
businesses, and individuals. Banks earn interest and fees based on the credit
profile of the client and the nature of the credit facility. The difference
between the cost of funds (which is the cost of the average interest rate paid
to deposit holders and savings account holders of a bank) and the interest
income earned by lending these funds is termed the ”net interest margin
(NIM).” Net interest margins are a core revenue stream for a bank.

The Indian banking system consists of 21 public sector banks (includes SBI
and IDBI bank), 25 private sector banks, 43 foreign banks, 56 regional rural
banks, 10 small finance banks, 4 payment banks, 1,589 urban cooperative
banks and 93,550 rural cooperative banks.

Role of Banks in the Economy

 What You Need to Know, continued.
Banks have an important role in the domestic and global economy. Banks enable capital
mobilisation, provide finance in the form of credit, and help expansion of the markets.
 Enable Capital Mobilisation
Banks act as intermediaries in the saving and investment cycle, and, thereby help reduce the
deficiency in capital accumulation that otherwise might exist in an economy. A sound banking
system attracts a large number of small savings from the general public. This helps convert
savings into active capital that generates productive assets, which otherwise might have
remained idle.
 Provide Finance in the Form of Credit
Credit is the key lubricant of all commerce and trade, both domestic and foreign, and banks are
at the centre of these activities. It is important to understand how the term “credit” is used in the
context of banking. Credit is a contractual agreement in which a borrower receives something of
value now and agrees to repay the lender at some date in the future, generally with interest. The
word is derived from Latin and means “belief, trust”. In the banking context, a lender entrusts
money to a borrower against the promise of interest payment and future principal repayment.
 Help Expansion of the Markets
Banks help commerce and industry by acting as intermediaries between buyers and sellers,
making it viable for industry and commerce to cultivate and locate markets that may not be
possible to reach otherwise.

Importance of Prudent
Lending
What You Need to Know, continued.

Regardless of the type of bank — public sector, private sector, or cooperative — banks are
commercial entities answerable to their respective stakeholders. They need to safeguard
depositors’ and investors’ funds alike.

Recall that banks accept funds from individuals and entities — depositors — and lend the money
to borrowers. The key element in this process is to protect the depositors from risk by ensuring
the borrowed funds are repaid on time with interest. Loans not performing or paying interest as
agreed are generally termed “bad loans,” and they have an adverse effect on the bank’s
performance and the economy.

Note: Based on the low net interest income of most banks, a single bad loan can wipe away the
profits earned from over 100 good loans repaid on time. It is therefore critical that every banking
professional who is part of the lending cycle be fully aware of the need for making well informed
and prudent credit lending decisions to avoid bad loans.
 When thinking about the importance of prudent lending, keep in mind the following:
 Some borrowers will at some point encounter difficulties repaying their loans. The extent of such
non-performing loans and outright loan losses is a major risk factor for banks. The rate of non-
performing loans and borrower default tends to move with economic cycles. In periods of
economic growth, non-performing loans and default rates tend to be lower, and vice versa.
 As a credit risk professional, it is critical to be aware of the latest changes in the business
environment and the macro economic conditions. By adopting prudent credit analysis and
decision practices, you share the responsibility of protecting your bank and safeguarding the
interests of the depositors and shareholders.

Sources of Finance
What You Need to Know, continued.

In India, business entities can be classified as “organised” and “unorganised”.

Their need for capital is met by various sources.These sources are broadly
classified as “formal” and “informal”.

Banks, Non-Banking Financial Companies (NBFCs), other term lending

institutions, and the securities markets are considered formal. They lend to
the organised business sector. Unorganised businesses often borrow in an
informal way from private money lenders, chit funds, and friends and
relatives.

It is a challenge for the formal lending institutions to bring the unorganised

sector, which includes micro-business enterprises, low-income groups, and
individuals, under the formal lending umbrella. The contribution of this
segment is important to the growth of the economy.

Banks and other formal financial institutions have, over time, developed a
customised bouquet of solutions to meet the specific needs of both the
organised and unorganised segments of the economy. To mobilise capital,
banks offer deposit schemes such as savings accounts, current accounts, and
fixed deposits. Similarly, to provide capital, banks offer loan facilities such as
fund-based working capital, term loans, and equipment financing, as well as
non-fund based facilities customised to meet the needs of various entities

Types of Banking
What You Need to Know, continued.
Based on customer type and borrowing needs, banks have segregated their
internal units to target these distinct segments. Understanding these various
segments will help you appreciate the underwriting approach and the
lending products you offer at the bank.

Retail Banking–

Also known as consumer banking, this division caters to the banking needs of individual
customers. Since retail banking deals with the public at large, banks use their branch network to
reach and service their customers. Product offerings include savings accounts, debit and credit
cards, personal loans, and other fee-based services such as lockers and foreign exchange
remittances.

Retail credit involves loans used by individuals. Products include credit cards, personal loans and
small-business loans. Due to the need for quick decision making, credit decisions are largely
based on a parameterised, or rules-based approach. A combination of actual financial
information as well as surrogate information helps the lender assess the individual’s repayment
capacity (with the help of bank statements, tax filings, and the like) as well as the security
offered.

Risk Diversification: Due to the small-ticket nature of these loans and the large volume of
customers, retail lending offers greater risk diversification to the bank than other forms of
banking.
Micro/Small and Medium Enterprises Banking–

Also know known as MSME or SME banking, this sector constitutes a wide array of customers,
including individual entrepreneurs, professionals and business entities. The credit needs of this
sector are fairly simple, but nonetheless more complex,than those of retail clients, as there is a
need for financing working capital and transaction products to manage their business operations.

SME credit involves fairly simple facilities, which cater to funding the purchase or lease of small
assets such as commercial vehicles or machinery, as well financing the working capital to
manage business operations. In most cases, the lending will be asset/collateral backed or in the
form of simple unsecured products such as overdrafts, business loans, and the like.

Due to a lack of detailed financial information (as well reliability issues regarding the
information provided), combined with the unorganised and diverse nature of these borrowers,
banks tend to rely largely on a “program-based lending”, which involves tailored lending
products for each segment. This can be in the form of trader loans, loans for professionals,
commercial vehicle loans, and so on. Credit decisions in the SME segment use some of the retail
lending approaches outlined above, as well as some aspects of commercial lending, with more
details on a case-by-case basis, and for discretionary led credit underwriting.
Commercial and Corporate Banking–
 Commercial and corporate banking deals with companies and institutions. Companies have
different banking needs than individuals. For instance, they may need letters of credit to facilitate
trade, cash management to make timely payments to suppliers, or to borrow long-term funds for
project expansion.

Corporate loans are typically large-ticket sized in nature. These lending needs are more complex,
and in many cases, may include multi-bank lending, unlike the sole lending that is seen in SME
banking. Corporate loans also tend to give rise to portfolio concentrations, as they are spread
across a smaller number of clients. A few loans going bad can adversely affect the profitability,
and even viability, of the bank. Banks use multiple banking and client-wise lending caps to
reduce the concentration risk in this segment.
Investment Banking–

Investment banking engages with companies to help them with strategic decisions such as raising
capital and advising on mergers and acquisitions.

Investment banking is largely a fee-based business emanating from advisory services. It is also
engaged in underwriting and the arrangement of capital for larger corporations. As such, credit
assessment assumes relevance when banks underwrite a capital-raising proposal for their
corporate clients.

While the advisory services side of the investment banking business typically does not tend to
generate any credit risk, the underwriting business and proprietary trading activities of banks
may give rise to significant levels of credit risk.

What You Need to Do

In your role as a banker/credit professional, you are well positioned to support both your bank
and the overall economy by following the best practices listed below:
 Understand and appreciate the role banks play as financial intermediaries.
 Understand lenders’ role in stimulating the economy.
 Be aware of and analyse the macroeconomic environment around inflation forecasts, interest rate
scenarios, GDP, and industrial growth rate trends.
 Keep abreast of changes in government policies that are linked to key sectors of the economy.
 Develop a better understanding of the various segments within your bank.
 Analyse the credit policies for your borrowing segment.
 Understand the prudent lending practices that have been put in place and learn how to identify
the right clients within these parameters.

How This is Useful

An understanding of financial intermediation will help you, as a banking or
credit professional, understand your role in the economy. It is also important
to understand how credit policy and sound lending practices help mitigate
the loss of capital due to bad loans. Both depositors and investors have
entrusted you with their money, and expect you to safeguard it by lending
only when you are sufficiently certain a loan will be repaid.

For example, you have read reports in the recent newspaper that the
consumer price index (CPI) has been rising significantly, and that the RBI has
been working to reduce the money supply as well as towards reigning in
borrowing rates. The reports also note that some of the SME sectors have
been impacted by the recent introduction of the Goods and Services Tax
(GST).

Your broad understanding of the underlying connections between these

indicators in terms of economic and policy changes and their impact on the
SME sector will help you build better credit decisions. Furthermore, if you
take into consideration the cautionary signals of these economic indicators,
you will be able to take proactive steps to mitigate potential bad credit, as
well as enhance your level of due diligence while sourcing new clients.
 Types of Customers and Legal Provisions lesson

When it comes to a borrowing request that you need to assess, you need to understand each legal
forms of a business, as your organisation may have differing policies and procedures for
extending credit to the different types of organisational structures.

This lesson discusses some of the basic forms and legal structures of business organisations.
Although the list provided here is short and generic, most lenders have policies regarding
extending credit to different legal forms of business. Those policies provide specific guidance for
the lender and protection for the organisation.

When reviewing the lesson, keep in mind that you must consult your own institution’s policies
and procedures for specific guidelines.

By the end of this lesson, you should be able to:

 Describe the various customer types and their key features.

 Describe the applicability of various Acts.
 Assess proposals involving partnership firms and limited companies.

To assess the credit risk of your client and structure a loan for approval, a credit professional
should understand the business model as well as the legal structure of the borrowing entity. To
help address this issue effectively, you should:
 Identify the borrower’s legal structure and collect/review the necessary documentation.
 Assess the credit policy implications and the degree of financial risk associated with the current
or proposed legal structure.
 Think ahead to the loan structure that may be involved with a given credit approval, and make
sure you will be able to mitigate risk with credit enhancements that match the legal structure.
 Assess whether there is a need to consult with an empanelled legal advisor of the bank.
In case of proposals relating to Company:
 Determine whether there are any clauses in the MOA and or AOA that prevent the bank from
financing as per the bank’s credit policy.
 Determine via the MOA, who the promoters/owners/directors are and whether their backgrounds
are in line with the activities of the business.
 Verify the powers of the authorized persons with regard to the execution of loan documents and
the extent of borrowing.
 Determine whether you have other sources to independently verify the authenticity of the
company documents.

M/S Srinath & Co., a partnership, approaches you for a credit facility of Rs. 20.00 lacs to
purchase machinery worth Rs. 25.00 lacs.They are prepared to contribute a margin of Rs. 5.00
lacs. There are four partners; namely, Mr. Srinath, Mr. Murali and Mr. Krishna and Master
Giridhar. Their shares of the partnership are 40%, 30%, 20%, and 10%, respectively.

They are seeking your guidance on the following:

 Documents needed for the loan request.
 Personal liability
 Who is needed to execute the documents as one of the partners is presently out of town.
 Whether they can authorize one of the partners to sign.
You’ve learned that in order to proceed with the loan request, they must;
 Submit their Partnership Deed, Certification of Registration (optional), and KYC documents for
each of the partners and the firm.

In this case, the partners are jointly and severally liable. However, the minor partner, Master
Girihar, is not liable for the loan, but is entitled to the benefits of the unit.

You tell them that, Yes, all the partners should sign the document by visiting the branch.
Additionally, a guardian will sign on behalf of the minor.

You also let them know that, Yes, they can authorise one of the partners to operate the account
by giving an authorisation letter signed by all the partners.
 You understand that lending to various types of SME businesses requires
considerable due diligence, which includes confirming the veracity of the
documents submitted. In this regard, the following actions will help you to do
so:

Recognise
The type of constitution (Individual/Partnership/LLP/Company) when a
proposal is received and review the key information provided in those
documents.
Identify
The legal structure of the company, and gather and review the necessary due
diligence documents.
Verify
The authenticity of the documents, identities, and profile of the people
involved in the business. Appropriately apply this information/due diligence
to the underwriting and lending process and procedures.
Discuss
With the prospective borrower to get further details about their background
and business-related information.
Decide
Whether to take the next steps in your credit appraisal and documentation in
consultation with internal department specialists.

M/S Vibrant Electronics Pvt Ltd. is a private limited company promoted by three members. The
sharing percentage of the promoters (A, B and C) are 40%, 35% and 25%. They have
approached your bank to open an account and for a credit facility of Rs. 50 lacs.

The company has submitted the following documents:

 Duly completed SME application form
 Memorandum of Association
 Articles of Association
 Company registration certificate
 Board resolution
 Other relevant KYC documents
Your branch SME credit officer is a new Probationary Officer and seeks your guidance on:
 Who can execute the documents of the company since the share in the capital is different for
each promoter.
 How to check that the company is genuine.
 Where to check for authorised capital particulars, etc.
 The information covered in this lesson will help you guide the officer as follows:
 Check the Board resolution to determine who can execute the documents. There will be specific
mention of this in the Board resolution.
 The Memorandum of Association will inform you of the promoters’ contribution, the company’s
borrowing limit, and the objectives of the company to run this particular business.
 By accessing the MCA site, you can ascertain the genuineness of the company by referring to the
registration number of the company.
 By referring to the PAN, the identity of both the individuals and the company can be established.
 By referring to the Aadhaar, we can verify the identity of promoters/owners of the company.

As a lender, you should verify your client’s borrowing needs and be able to trace their credit
request to a particular business need. The structural features of the credit facility must then match
the characteristics of that underlying business need.

A prospective SME entrepreneur may approach your bank with a predetermined request in mind.
For example, they may request a term loan. As part of your due diligence and credit appraisal,
you need to determine whether the request is appropriate or whether a different structure, or loan
features, are more suitable based on the credit purpose and risk profile.

Essentially, the credit facilities offered can be classified as follows:

1. Physical Outflow of Funds

Fund-based – Physical Outflow of Funds from the bank.
Non-fund-based – the facility does not entail the physical outflow of funds.
2. Collateral or Security
Secured facilities – partially or fully secured by collateral.
Unsecured facilities – no collateral.

3. Tenor of the Credit Facility

The classification based on the period between the disbursement and closure of the loan.

Fund-Based Facilities–

Various credit facilities have different structures and attributes, as follows:

 DEFINITIONS: A term loan is normally a medium or long-term facility

extended by banks and other financial institutions. This type of loan is used
for the acquisition of assets, expansion, diversification, and modernisation.

 SECURITY: Term loans are secured loans. Assets acquired through term
loans serve as the primary security and the other assets of the company serve
as collateral.
  TERM: The term of loan is classified as short term for up to three years, as
medium term from three years to seven years, and long term for seven years
and above.

 REPAYMENT: Repayable as per cash flow. This could be in equal monthly

instalments (EMI), quarterly instalments or half-yearly instalments, or as a
lump sum at the end of the term (bullet repayment).

 MARGIN: The bank typically finances 75 percent of the cost of the

underlying asset. The business finances the remaining 25 percent, although
this may vary depending on the risk assessment.

 RELEASE: Payment is made directly to the supplier and receipted. This

ensures the funds are leased for the specific use of the loan as requested.

 INTEREST/PRICING: Shall depend upon the rating of the SME borrower.

The interest is generally linked to the Marginal Cost of funds-based Lending
Rate (MCLR). MCLR will be discussed in later chapters.

The detailed descriptions of the various types of facilities are included in the PDF document:

Non-Fund-Based Facilities–

Non-fund-based facilities do not involve an immediate outlay of funds. The bank serves as a
guarantor to the borrower to procure raw materials. The bank’s obligation is realised only when
the borrower fails to meet their payment obligations. These facilities are a good source of
revenue for the banks as they do not involve any outflow of funds, but generate income by way
of commissions and processing fees, etc. The credit risk is comparatively low.

Let us discuss the different types of non-fund-based facilities.

Letter of Credit (LC)

When a SME wishes to purchase raw material or machinery from a seller, either domestic or
foreign, the seller generally demands an assurance for payment. In such a scenario, the bank will
extend a facility called a letter of credit (LC) which is a non-fund-based facility guaranteeing
payment to the seller, subject to fulfillment of the terms of the LC. Using this facility, the SME
can purchase goods without advance payment of funds. This facility also does not block funds.

Bank Guarantee
Customers undertake various contract work for different government departments. To ensure
prompt and proper execution of the work, the government department may insist on a
performance guarantee issued by a bank.

Banks issue both Performance and Financial guarantees on behalf of the customer after due
evaluation of the creditworthiness and capacity of the customer to perform the work. If the
customer fails to perform the work as per the contract, they will be in default and the guarantee
will be invoked. This will result in the bank making the payment.

Different types of bank guarantees:

 A bid bond guarantee is used to ensure that companies that bid for projects as
part of a tender process accept and/or execute the awarded contract.
 A performance bond guarantees payment to a party in the event of non-
performance of duties by another party as per the terms of the contract.
 An advance payment guarantee acts as collateral for reimbursing the advance
payment from the buyer if the seller does not supply the goods as per the
specification in the underlying contract.
 A financial guarantee is an irrevocable indemnity assuring counterparties that
the financial obligations of another party will be met.

Deferred Payment Guarantee

When a supplier of machinery agrees to sell the machinery on deferred terms or instalment
payments, our customer is required to produce a bank guarantee to ensure the payment
instalments. The bank assesses the proposal as if it is a term loan requiring a margin/down
payment.

In the event the customer defaults on the instalments, the bank must pay the instalment amount.
Hence this type of guarantee called a deferred payment guarantee.