Principles of Lending

By , Akshay Jain Aashish Jain

Bank Lending Principles 5 Cs of good Lending

- Character - Capital - Capacity - Collateral - Conditions

Principles of good lending

Character : - Market Report - Credit history - Bank Report - Published Information: website, Stock Exchange, Industry Sources, Annual Reports - RBI website, Credit Information System - Credit Information Bureau (CIBIL)

Principles of good lending

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

Principles of good lending

Capital - Owners stake in business - Investors, JV partners - Margin money - Adequacy of capital: statutory requirements - Ratios: * Industry Norms on ROAA and ROE * EPS & PE ratio

Principles of good lending

Collateral (Security) - Marketability - Liquidity - Physical possession/ Storage - Charging the security * Mortgage * Hypothecation/ Pledge * Lien

Principles of good lending

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

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

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

Principles of sound lending

a) Safety Banks are trustee of public money. Banks deposits are always payable on demand. Bank has to maintain trust of depositor for ever. As such the first and foremost principle of lending is to ensure safety of funds lent. By safety means that the borrower is in a position to repay the loan, along with interest. Further, it is just not the capacity of the borrower to repay but also his willingness to repay. The former depends on his tangible assets and the success of his business. The latter depends on the borrowers character. 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. In practice, banks ensure that they adhere to this principle by taking collateral security that is marketable, apart from primary security, which the bank can dispose off in the event of default. In more recent times, bankers have begun to concentrate more on the business aspect of the borrower, i.e., the purpose and viability of the business rather than on the collaterals. Thus, bankers have begun to treat the entire business as security and in this manner moved away from the traditional concept of collaterals. Thus bankers must take utmost care in ensuring that the business for which a loan is sought is a sound one, and that the borrower is a person of integrity who is capable of carrying out his business successfully.

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. It is to be seen that money lent is not going to be locked up for a long time. The money should return to the bank as per the repayment schedule. 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. It is to be kept in mind that various deposits have various maturities and some of it would also be payable on demand. A banks 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. Further, liquidity would also refer to the quality of assets, which should be easily convertible into cash without any loss of value. Thus the concept of liquidity entails the banker to look for easy saleability and absence of risk of loss on sale of asset, which has been taken as collateral.

Principles of sound lending

c) Profitability Bank are not charitable institutions. All banks are profit-earning institutions. The ultimate objective of lending is to earn profits. Banks receive interest on loans and advances lent, and they pay interest to their depositors. This difference between the receipts and payments will be the banks gross profit. Banks further incur various expenses as any organisation does. After accounting for all such expenses and provisions, banks have to earn a reasonable amount as net profit (NIM) so that dividends can be paid to its shareholders. 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. Hence it is important that whatever the business the bank engages itself with, the business be profitable enough not just to cover its costs but to ensure generation of surplus funds or margin. 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 It is also a recent practice to analyse the profitability of operations vis--vis particular customers. This approach, known as the Customer Profitability Analysis (CPA), 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. 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, 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. 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. There is a direct relationship between profit and pricing of service offered by the banker.

Principles of sound lending

d) Purpose While lending the funds, the banker enquires from the borrower the purpose for which he seeks the loan. Banks do not grant loans for each and every purpose. They ensure the safety and liquidity of their funds by granting loans only for productive purposes. The funds lent should be put to optimum use. 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. In some cases, the banks grant loans for personal expenditure and for short/medium term like for education etc. Loans are now available for varied purposes these days. 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

Principles of sound lending

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

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. While this is no doubt an adequate measure, there are other unforeseen contingencies against which the banker has to guard himself. Further if the bank lends large amounts to a single industry or borrower, 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, the banker follows the principle of diversification of risks based on the famous maxim never keep all the eggs in one basket. By lending funds to different sectors, a bank can save itself from the slump in some sectors by way of prosperity in the others. Banks have to lend to a large number of industries and borrowers so that the risk gets diversified.

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