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CHAPTER I
Principles of Lending & Types of Credit Facilities
Introduction
The economic growth of any country is determined by the investments made by the various
entities resulting in increased production measured by the growth in GDP of such economies.
The credit provided by the banks is an important driver for such growth. In most countries,
bank loans are the main source of financing for small and medium-sized enterprises.
In fact banks are financial intermediaries that raise funds by way of deposits or otherwise and
lend or invest the same and make profits in the process. So lending is one of the key functions
of the banks.
The deployment of credit by a bank depends on the availability of the funds and their ability
to mobilise such funds which in turn is determined by the monetary and credit policy of the
Reserve Bank of India which is influenced by the consideration of growth and the
inflationary tendencies prevailing in the economy.
Since interest income is the major source of income for the banks the more they lend the
more they earn. But lending has its own risk and the process is based on a risk - return
analysis. Only if they can maintain the quality of the assets in the loan portfolio they can
ensure the envisaged returns. They cannot take unbridled risks in the lending and credit
deposit ratio is criteria used by RBI to monitor the adequacy and safety level of lending by
the banks.
Credit deposit (CD) ratio indicates how much a bank lends out of the deposits it has
mobilised. It reflects how much of a bank's core funds are being used for lending. A higher
ratio indicates more reliance on deposits for lending and vice-versa. The RBI does not
stipulate a minimum or maximum level for the ratio. But, a very low ratio indicates that
banks are not making full use of their resources. And if the ratio is above a certain level, it
indicates a pressure on resources
The ratio gives the first indication of the health of a bank. A very high ratio is not considered
desirable because, in addition to indicating pressure on resources, it may also hint at capital
adequacy issues, forcing banks to raise more capital. Moreover, asset-liability mismatches
can also become a matter of concern
The Reserve Bank has voiced concerns whenever there is very high CD ratio as it could have
financial stability implication at the systemic level.RBI also monitor the incremental credit
deposit ratio as high incremental C-D ratio implies that banks do not have adequate resources
to sustain robust credit expansion for the medium term.
In short lending is one of the core functions of the banks. It is the main source of income for
the banks. The difference between the interest they get on the loans and advances and the
interest they pay on the deposits is called the net interest income which is the major
contributor towards the profit of the banks.
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Principles of lending
Banks always take care to see that they build only quality assets. So they follow certain basic
principles while lending.
1. Safety
Banks have to ensure that the money lend by them are safe. That it will be repaid by the
customers in time with interest. The creditworthiness and integrity of the borrowers, the
viability of the project for which funds are lend, its end use , the security available etc are
factors connected with it.
2. Profitability
Profits earned by the banks are one of the key factors that determine the strength of the
balance sheet of any bank. Profit is vital for the banks to ensure their sustenance and growth.
Banks have to pay reasonable return to the investors of the bank by way of dividend, capital
appreciation etc for which the level of profits they generate is a determinant factor.
3. Liquidity
Banks have to repay their depositors the money they have deposited when they demand the
same as per the terms and conditions made at the time of depositing the money. So the asset –
liability management by the bank plays an important role in this aspect and the banks should
have sufficient liquidity to meet their repayment obligations.
4. Risk Management
Lending by banks involve an element of risk. All the borrowers may not repay the money in
time. So credit risk has to be managed properly by diversifying the portfolio of assets, doing
risk rating and by effective credit monitoring.
The “Cs” of lending
Normally it is said as the Cs of lending namely, the character, capacity, capital collateral and
the conditions.
Character
Identification of the borrower is the most important aspect of lending. He should be of high
integrity and creditworthiness. The character of the borrower is a very material factor that
determines the quality of the asset the banks’ create.
Capacity
The borrower should have the necessary capacity to carry out the activity successfully. He
should have the necessary skills for running that unit or should have skilled people under him
and he should be able to manage the affairs in a professional manner.
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Capital
The borrower should have reasonable stake in the project. He should be in a position to bring
sufficient capital as margin as per the norms of the bank.
Collateral
Banks may insist for collateral security for the facilities to be granted as it serves as a cushion
for the banker in case the borrower fails to meet its commitment to the banker. It is a credit
risk-mitigating tool for the bank.
Conditions
Macro economic conditions are a critical factor that determines the success of any unit. If the
macro economic conditions are favourable such as the particular type of industry for which
finance is extended is doing well, the chance of success of the unit will be more.
The stages of lending
Different stages are involved in the process of lending. The bank makes a pre-credit appraisal
to decide whether to grant the finance or not. If the decision is favourable it goes to the
assessment stage where the quantum of finance and the type of facilities to be granted will be
determined. On the basis of the assessment sanction order will be issued which contains the
terms and conditions of the sanction and documentation based on sanction order conditions
will be done followed by disbursal and post credit monitoring. Thereafter the facilities are
renewed / recalled depending on the quality of the credit.
Concept of margin
Banks will not grant the entire amount required for any activity/ project. A part of the cost of
the same will have to be met by the borrower which is his stake and it is called the margin for
such credit facilities. Further banks will always stipulate margin on the primary and collateral
security it obtains for such facilities to safeguard against any diminution in the value of such
securities. Primary security indicates the assets created by the lending and collateral
securities are other assets taken as security for the credit. The margin norms are determined
by RBI guidelines and the loan policies of the respective banks.
Once the bank has decided that the finance can be granted, it will have determine the
type of the facilities the customer requires.
Types of credit facilities
Banks extend both fund based and non fund based facilities to its customers.
Fund based facilities
In the case of fund based limits there is an outlay of funds, the borrower gets the funds which
can be utilised for immediate payments of his commitments and reap the benefits of discounts
and concessions associated with such immediate payments. The banks in such cases get
interest income.
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Fund based facilities can be by way of working capital loans as well as term loans. Working
capital finance is extended for acquiring current assets like goods, receivables etc and term
loans are extended for acquiring fixed asset such a land , building, machineries etc.
Non Fund based facilities.
In the case of non fund based facilities the borrower will not be provided funds by the banks
but a commitment to meet their payment obligations in case they fail to meet such obligations
and the banks give the commitments to others to whom the borrower is obliged to. So it is a
contingent liability and the bank earns commission for such facilities. The commission is
much lower that the interest the banks’ charge for funded facilities and the borrowers stand to
gain in that respect. Such commissions are classified as other income for the banks and the
banks also get the advantage of lesser capital requirement as per capital adequate norms for
non funded facilities compared to funded facilities.
In the case of non fund based facilities there is no immediate outlay of funds. Non fund
based facilities include bank guarantees and letter of credit
Working capital facilities can be by way of running accounts like cash credit and overdrafts,
or payment by installments by way of demand loans or it can be by way of purchasing/
discounting of bills.
Cash credit
In the case of cash credit remittances and withdrawals are permitted and hence it is called a
running account. Bank will fix a limit up to which the customer can borrow and the debit
balance in the account cannot exceed the same. Further withdrawals will also be regulated by
the value of the primary security such as goods and receivables held by the customer from
time to time and also the margin stipulated by banks. This concept is called by the name
drawing power.
Overdraft
Banks also grant overdraft facilities against securities like fixed deposit etc. A certain limit is
fixed by the bank in such accounts taking into account the value of the deposit/other
securities and the customer can operate within this limit.
Demand Loans
The bank advances a fixed amount for a shorter period, which has to be repaid in installments
or in lump sum. Normally it will not be a running account.
Bills purchased / discounted
Bills of exchange are drawn by a seller on the purchaser of the goods as per the terms agreed
by them. It can be a demand bill or a usance bill. Banks purchases a demand bill and
discounts a usance bill.
Demand bills are payable on demand and are also known by the name sight bills. Only when
the payment is made by the drawee of the bill, the banker will release the documents of title
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to goods such as lorry receipt, railway receipt which are forwarded by the seller to the buyer
through the bank.
Usance bills are payable by the purchaser only after a certain period known as the credit
period allowed by the seller. So banker releases the documents like lorry receipt/ railway
receipt to the drawee without payment but on accepting the bill of exchange by him.
Term loans are extended banks for purchasing machineries, vehicles and other fixed assets.
It is normally repaid by installments over a period by the borrower. The installments can be
equated monthly installment or graded installments etc. The borrower will bring a certain
percentage of the cost of the asset for which finance is granted as margin and the rest will be
given by the bank as loan.
Non- fund facilities
(a) Guarantees
Banks will be issuing guarantees on behalf of their customer undertaking to pay the
beneficiary of the guarantee a certain amount of money in case the customer fails to fulfill the
obligations it has entered with the beneficiary. The bank will pay the money to the
beneficiary as and when they demand the same within the validity period of the guarantee.
The banks will charge commission from the customer for issuing such guarantees.
The guarantees issued can be a financial guarantee, performance guarantee or a deferred
payment guarantee.
In the case of financial guarantee banks undertake to pay the beneficiary a certain sum in
case of any default by the borrower in fulfilling the terms of the contract, which the customer
has entered with the beneficiary. Banks will make the payment to the beneficiary on roper
invocation and not concerned with any dispute between the customer and the beneficiary in
respect of the terms of contract entered between them.
In the case of performance guarantee he bank is guaranteeing performance by its customer
and in case of default bank will pay a certain sum of money to the beneficiary.
Deferred payment guarantee normally arises when the customer purchases
machineries/fixed assets on credit from its supplier. That is the payment has to be made to the
supplier in installments over a period of time. The bank guarantees the payment of
installments on due dates stipulated.
Letter of credit (LC)
It is an arrangement whereby the LC issuing bank at the request of its customer
(buyer/opener) undertakes to pay the beneficiary (seller) on submitting the documents
stipulated in the LC as per the terms mentioned in such LC. So the supplier is ensured
payment and the purchaser is ensured of the supply as evidenced by the documents submitted
by the seller under the LC. It can be an inland LC or an import LC depending whether the
transaction is within the country or across the borders.
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In the case of LCs banks deal with documents only and make payments if the documents are
in order. The banker is not concerned with any dispute between the buyer and the seller with
respect to the goods or with other terms of the contract.
Next stage banks will determine the quantum of finance it can extend under various
facilities.
Banks use various financial tools such as ratio analysis, cash flow and fund flow analysis etc
to ascertain the quantum of finance that can be extended to the borrower under various credit
facilities.