Uses of Bank Funds and Applications

Types of Lending
• 1. Fund based lending, where the lending
bank commits the physical outflow of funds.  It
is a single advance in which the entire amount
of assistance is disbursed at one time only,
either in cash or by transfer to the borrower’s
account
Example:
1) Loan to all categories

2) Overdraft

3) Cash Credit

4) Bills Purchased/Discounted

5) Working Capital Term Loans

2. Non-Fund Based Lending
• The Non-Fund based Credit Facilities are nature of
promises made by Banks in favor of a third party
to provide monetary compensation on behalf of
their clients, where the lending bank does not
commit any physical outflow of funds.
• Examples: Letter of Credits
Guarantees
• 3. Asset-based lending: This is an emerging
category of bank lending. In this type of
lending, the bank looks primarily or solely to
the earning capacity of the asset being
financed, for servicing its debt. In most cases,
the bank will have limited or no recourse to
the borrower. Specialized lending practices,
such as securitization or project finance fall
under this category.
 Credit Analysis Process
• Step 1—Building the ‘credit file
• Step 2—Project and financial appraisal
• Step 3—Qualitative analysis
• Step 4—Due diligence
• Step 5—Risk assessment
• Step 6—Making the recommendation
Loan Pricing Strategy
A very simple loan-pricing model assumes that the rate of
interest charged on any loan includes four components:
Loan Price= Cost of Funds + Service Cost + Risk
Premium+ Desired Profit
1. the funding cost incurred by the bank to raise funds to
lend, whether such funds are obtained through
customer deposits or through various money markets
2. the operating costs of servicing the loan, which include
application and payment processing, and the bank's
wages, salaries and occupancy expense;
3. a risk premium to compensate the bank for the degree of
default risk inherent in the loan request; and
4. a profit margin on each loan that provides the bank with an
adequate return on its capital.

Example: how this loan-pricing model arrives at an interest rate on a

loan request of $10,000. The bank must obtain funds to lend at a cost
of 5 percent. Overhead costs for servicing the loan are estimated at 2
percent of the requested loan amount and a premium of 2 percent is
added to compensate the bank for default risk, or the risk that the
loan will not be paid on time or in full. The bank has determined that
all loans will be assessed a 1 percent profit margin over and above
the financial, operating and risk-related costs. 
Step 3: Assess Default Risk
E (r )  P( R) * r  P( D) * ({R( p  Pr) / P}  1)

where E(r) is the expected rate

• P(R) is the probability of recovery
• r is the contracted rate of interest
• P(D) is the probability of default
• P is the principal amount
• R is the recovery rate in the event of default
Risk premium is the difference between contractual
rate and expected return on loan.

Step 4: Fixing the Profit Margin

We know that ROE=ROA*EM, By rearranging the

term…..

ROA=ROE/EM