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Principles of Lending

By , Akshay Jain Aashish Jain

Capital .Capacity .Collateral .Character .Conditions .Bank Lending – Principles 5 Cs of good Lending .

Bank Report .Principles of good lending • Character : .Credit Information Bureau (CIBIL) .Credit history .RBI website. Industry Sources. Stock Exchange.Market Report .Published Information: website. Annual Reports . Credit Information System .

Past Track record * Financials.Management team. Annual Report.Technical feasibility . Other docs * Operation of the account .Joint Venture partners .Economic viability . in-house expertise .Principles of good lending • Capacity : .

Owner’s stake in business .Investors.Principles of good lending • Capital .Adequacy of capital: statutory requirements . JV partners .Ratios: * Industry Norms on ROAA and ROE * EPS & PE ratio .Margin money .

Principles of good lending • Collateral (Security) .Physical possession/ Storage .Marketability .Charging the security * Mortgage * Hypothecation/ Pledge * Lien .Liquidity .

supervision & monitoring. eg * Raising capital with in given time * Recruiting professionals/ technocrats capable to run the business * Fulfilling any other area of deficiency .Principles of good lending • Conditions .General conditions-follow up.Specific conditions. Annual Review etc .

potential • Managerial skills .Project Appraisal • Technical Feasibility • Financial Viability • Market potential & Clients strength in tapping the mkt.

Analysis of Financial data • Balance Sheet • Profit & Loss account • Ratio analysis • Cash flow analysis .

Post Sanction • LOI/ Offer letter/Term-sheet -Details of the facilities approved -Terms of sanction -Security for the loan Documentation Disbursement Monitoring & Follow-up Periodical Review • • • • .

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• Thus.Principles of sound lending a) Safety • Banks are trustee of public money. and that the borrower is a person of integrity who is capable of carrying out his business successfully. bankers have begun to treat the entire business as security and in this manner moved away from the traditional concept of collaterals. i. apart from primary security. • In more recent times. banks ensure that they adhere to this principle by taking collateral security that is marketable.. Bank’s deposits are always payable on demand. 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. • Thus bankers must take utmost care in ensuring that the business for which a loan is sought is a sound one. which the bank can dispose off in the event of default. • The banker should lend to a reliable customer who can and will repay the loan within the prescribed period of time after generating surplus from business such that doubtful debts are avoided. .e. Bank has to maintain trust of depositor for ever. • In practice. along with interest. • The former depends on his tangible assets and the success of his business. • By safety means that the borrower is in a position to repay the loan. • The latter depends on the borrower’s character. bankers have begun to concentrate more on the business aspect of the borrower. the purpose and viability of the business rather than on the collaterals.

which has been taken as collateral. Further. liquidity would also refer to the quality of assets. It is to be seen that money lent is not going to be locked up for a long time. It is to be kept in mind that various deposits have various maturities and some of it would also be payable on demand. which should be easily convertible into cash without any loss of value. • • • • • . 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.Principles of sound lending • • • • • b) Liquidity The term liquidity refers to the extent of availability of funds with the banker for providing credit to borrowers. Thus the concept of liquidity entails the banker to look for easy saleability and absence of risk of loss on sale of asset. The money should return to the bank as per the repayment schedule. 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.

• This difference between the receipts and payments will be the bank’s gross profit. • Hence it is important that whatever the business the bank engages itself with. and they pay interest to their depositors. • 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. • Banks further incur various expenses as any organisation does. • After accounting for all such expenses and provisions. • It is prudent for the banker to consider overall profitability of the entire business that is undertaken rather than the profitability against each .Principles of sound lending c) Profitability • Bank are not charitable institutions. • The ultimate objective of lending is to earn profits. banks have to earn a reasonable amount as net profit (NIM) so that dividends can be paid to its shareholders. the business be profitable enough not just to cover its costs but to ensure generation of surplus funds or margin. All banks are profit-earning institutions. • Banks receive interest on loans and advances lent.

• This approach.Principles of sound lending c) Profitability • It is also a recent practice to analyse the profitability of operations vis-à-vis particular customers. enables the banker to decide the extent to which he can compromise on the profitability aspect so that a competitive rate can be offered to customer. a very conscious and careful exercise is called for on his part in order to strike a proper balance between the twin aims of making a desirable level of profit and at the same time offering a competitive price for the product/service. There is a direct relationship between profit and pricing of service offered by the banker. known as the Customer Profitability Analysis (CPA). • This is the kind of approach that is required of a banker in order to entice new customers to his fold while retaining the existing customers. • This analysis is done when more than one service is offered by the bank and to attract more customers. . • In the current context of the availability of freedom to a banker in the matter of pricing credit and services.

• Banks do not grant loans for each and every purpose. • The funds lent should be put to optimum use. • Loans are now available for varied purposes these days. • Loans are not to be granted for speculative and unproductive purposes like hoarding stock or for anti-social activities. since apart from the morality of such activities. there are also inherent risks involved with regard to the repayment of such loans. • Loans that are meant for personal expenditure like marriage cane be refused.Principles of sound lending • d) Purpose • While lending the funds. • In some cases. the banker enquires from the borrower the purpose for which he seeks the loan. • They ensure the safety and liquidity of their funds by granting loans only for productive purposes. • It is however the duty of the bank to keep in mind that the other principles of lending are adhered to. which in turn will automatically ensure that this . the banks grant loans for personal expenditure and for short/medium term like for education etc.

term deposits etc. • It may be a plot of land. • It is the duty of the banker to check the nature of the security and assess whether it is adequate for the loan granted. building. • Apart from the collateral. his character and capacity. . the security if accepted must be adequate and readily marketable. the banker has also to consider other factors such as capital of the borrower. easy to handle and free from encumbrances. insurance policies. • There may even be cases where there is no security at all. • The security and its adequacy alone should not form the sole consideration for judging the viability of a loan proposal. • The evaluation of the borrower is an important activity of the banker and this topic is dealt with in detail in the forthcoming pages. • The banker must realise that is it only a cushion to fall back upon in case of need. • Nevertheless. gold ornaments.Principles of sound lending • e) Security • The security offered against the loans may consist of a large variety of items. flat.

Further if the bank lends large amounts to a single industry or borrower. the banker follows the principle of diversification of risks based on the famous maxim ‘never keep all the eggs in one basket’. Banks have to lend to a large number of industries and borrowers so that the risk gets diversified. a bank can save itself from the slump in some sectors by way of prosperity in the others. By lending funds to different sectors. . 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. there are other unforeseen contingencies against which the banker has to guard himself. While this is no doubt an adequate measure.Principles of sound lending • f) Risk management through diversification • A prudent banker always tries to select the borrower very carefully and takes tangible assets as security to safeguard his interests.

Thank you .