Revise Lecture 19
•Basic Lending Principles
Basic Lending Principles
•
Safety Issues
Basic Lending Principles
Safety Issues
• The persistent failures of banks to lend
sensibly in Pakistan and in many other
countries have brought the question of safety
in lending to the fore;
• Why do banks persistently lend so
imprudently and how should lending be done
at minimum risk?
Basic Lending Principles
Safety Issues
• One essential problem is the human and
managerial challenge of motivating employees
of banks to cater to the interest of the owners
(shareholders) of the bank.
• The history of banking is replete with episodes
of employees favouring friends and relatives
with loans.
Basic Lending Principles
Safety Issues
• In some countries, there are well-defined
market rates for bribes for obtaining loans
from banks.
• This problem is also present in Pakistan,
though the record of Pakistan’s banking
system in this aspect is much better than that
of many other countries.
Basic Lending Principles
Safety Issues
• Another aspect of the problems of banks
concerns prudent levels of leverage.
• A bank is a financial intermediary with fairly
small equity capital, which borrows money
from depositors and invest it into risky assets.
This involves a high degree of leverage
Basic Lending Principles
Safety Issues
• Leverage, at the level of the bank, is
dangerous regardless of the quality of credit
analysis which has gone into each loan.
• High leverage generates high risk and high
returns. If high returns are obtained, the bank
takes the profits but it is protected from high
losses by the government.
Basic Lending Principles
Safety Issues
• Regulators have tried many policy initiatives
aimed at obtaining a banking system which has
controlled leverage, high quality lending and
thus, a reduced risk of failure.
• These include capital adequacy requirements
based on clumsy measurement of risk,
prohibition of lending against real estate,
restrictions on lending against shares, rules
governing collateral, etc.
Basic Lending Principles
Safety Issues
• A riskless loan is one that is fully collateralised
using actively traded assets.
• These assets should be traded objects so that a
‘market to market’ can be done daily, to ensure
that the collateral is always larger than the
outstanding loan.
• The value of the asset that is measured when
marking to market should be the liquidation
value., thus taking into account the problems
faced by the bank when selling off the assets.
•
Diversification of Risk
Basic Lending Principles
Diversification of Risk
• Diversification in banking has been a topic of
discussion in the literature for decades.
• It effects on performance, risk, efficiency and
firm value have been examined extensively.
• Diversification does have a significant impact
on a bank’s risk as well as its performance.
Basic Lending Principles
•
Benefits of Diversification
Basic Lending Principles
Benefits of Diversification
• One of the most common benefits associated
with respect to diversification is a lower cost
of capital.
• Banks, with some level of global diversification
have access to different capital markets which
could lead to a lower cost of funds through a
larger deposit base.
Basic Lending Principles
Benefits of Diversification
• Furthermore, the potential for more efficient
internal capital markets is another of cited
benefit to diversification.
• Another benefit associated with activity
diversification is the ability to gain economies
of scale / scope for the organization.
Basic Lending Principles
Benefits of Diversification
• An example might be bank which collects
information credit information on potential
borrowers. With this information, the bank
may be able to offer these potential clients
insurance products or underwriting services at
a lower cost because much of the information
needed has already been collected when
evaluating the loan application.
Basic Lending Principles
Benefits of Diversification
• Benefits associated with market power have also
been advanced. The argument suggests that
banks may diversify their activities or their
operations geographically to gain or maintain
market share.
• Finally, an important benefit that has been
proposed by some is the ability for organizations
to reduce earnings volatility by spreading
operations across areas with different economic
environments.
Lecture 20
•Loans and Advances
Loans and Advances
• Lending money is one of the two major
activities of any bank.
• The bank acts as an intermediary between the
people who have the money to lend and those
need money to carry out business
transactions.
Loans and Advances
• A loan is granted for a specific time period.
• Generally, commercial banks provide shortterm loans. But term loans, i.e. loans for more
than a year, may also be granted.
• The borrower may be given the entire amount
in lump sum or in instalIments.
Loans and Advances
• Loans are generally granted against or in
exchange of the ownership (physical or
constructive)of various type of tangible items.
• Some of the securities against which the
banks lend are;
Loans and Advances
1.
2.
3.
4.
5.
6.
7.
Commodities
Debts
Financial instruments
Real estate
Automobiles
Consumer durable goods
Documents of title
•Classification of Loans
Loans and Advances
• Bank loans can be classified as follows
according to the activity being financed;
1. Priority sector lending
2. Commercial lending
Loans and Advances
Priority sector lending
• The Government of Pakistan, through the
instrument of SBP, mandates certain types of
lending on the banks operating in Pakistan
irrespective of their origin.
• SBP sets targets in terms of percentage (of total
money lent by the banks) to be lent to certain
sectors which, in its perception, would not have
access to organized lending market or could not
afford to pay the interest at the commercial rate.
Loans and Advances
Priority sector lending
• This type of lending is called priority sector
lending.
• Financing of small industry, small business,
agricultural activities and export activities fall
under this category.
• This is also called directed credit in the
Pakistan banking system.
Loans and Advances
Commercial lending
• Commercial lending is the mainstay of
Pakistan banking, its bread and butter activity.
• Historically, this activity had been relegated to
a secondary position as banks were driven by
the desire to excel themselves in what is know
as priority sector banking.
Loans and Advances
Commercial lending
• Today, many banks focus on commercial
lending for improving their bottom lines.
• Fresh and innovative products are being
launched to facilitate the corporate customer
who forms the core of this business. There is
big competition among banks to secure bigger
share of this business.
Loans and Advances
Commercial lending
• At present, commercial loans are available for
practically any kind of activity and also for
both long and short tenures.
• Based on customer profile, these loans are of
two types;
1. Corporate loans
2. Retail loans
•
Advances
Loans and Advances
• An advance is a credit facility provided by the
bank to its customers.
• It differs from a loan in the sense that the
latter may be granted for a longer period, but
the former are normally granted for a short
period of time.
Loans and Advances
• Further, the purpose of granting advances is to
meet the day-to-day requirements of
business.
• The rate of interest charged on advances
varies from one bank to another.
Loans and Advances
• Bank grant short-term financial assistance by
way of;
1. Cash credit
2. Overdraft
3. Discounting of bills
Loans and Advances
Cash Credit
• Cash credit is an arrangement whereby the
bank allows the borrower to draw amount up
to a specified limit.
• The amount is credited to the account of the
customer. The customer can withdraw this
amount as when he requires. The interest is
charged on the amount actually withdrawn.
Loans and Advances
Cash Credit
Cash credit is granted as per the terms and
conditions agreed upon with the customers.
This type of financing is similar to a line of
credit.
1. Advances against the Security of Goods
2. Advances against Life Insurance Policies
3. Advances against Stock Market Securities
Loans and Advances
Cash Credit
4. Advances against Fixed Deposit Receipts
5. Advances against Book debts
6. Advances against Real Estates
7. Advances against Supply Bills