The primary function of a bank is to receive deposits and lend loans, the majority of the funds are used for lending and this also considered as the major source of income for the bank. But lending is accompanied by risk, therefore a banker must be cautious in this aspect.
A loan is granted for a specific time period.
Generally, commercial banks provide short term loans. But term loans like loans for more than a year may also be grated.
The borrower may be given the entire amount in a lump sum or in installments.
What are the Different Principles of Sound Lending
A banker must be extra careful while granting loans. A banker should take the following precautions:
1. Safety
The most important golden rule for granting loans is the safety of funds.
The main reason for this that the very existence of the bank is dependent upon the loans granted by him.
In case the bank does not get back the loans grated by it, it might fail.
A bank cannot and must not sacrifice the safety of its fund to get a higher rate of interest.
2. Liquidity
The second important golden rule of the grant loan is liquidity. Liquidity means the possibility of converting loans into cash without loss of time and money.
Needless to say, the funds with the bank out of which he lends money are payable on demand or short notice.
As such a bank cannot effort to block its funds for a long time.
Hence, the bank should lend only short term requirements like working capital.
The bank cannot and should not lend for long term requirements, like fixed capital.
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3. Return or Profitability
It is another important principle. The funds of the bank should be invested to earn the highest return, so that it may pay a reasonable rate of interest to its customers on their deposits, reasonably good salaries to its employees and a good return to its shareholders.
However, a bank should not sacrifice either safety or liquidity to earn a high rate of interest.
Of course, if safety and liquidity in a particular case are equal, the banker should lend its funds to aa person who offers a higher rate of interest.
4. Diversification
One should not put all his eggs in one basket is a proverb which very clearly explains this principle.
A bank should not invest all its funds in one industry. Incase that industry fails, the banker will not be able to recover his loans.
Hence, the bank may also fail. According to the principle of diversification, the bank should diversify its investments in different industries and should give loans to different borrowers in one industry.
It is less probable that all the borrowers and industries will fail at one and at the same time.
5. Object of Loan
A banker should thoroughly examine the object for which his client is taking loans.
This will enable the bank to assess the safety and liquidity of its investment. A banker should not grant loans for unproductive purposes or to buy the fixed assets.
The bank may grant loans to meet working capital requirements.
However, after the nationalization of banks, the banks have started granting loans to meet loan term requirements.
As per prudent banking policy, it is not desirable because of term lending by banks a large number of banks had failed in Germany.
6. Security
A banker should grant secured loans only. In case the borrower fails to return the loan, the banker may recover his loan after realizing the securing.
In the case of unsecured loans, the chances of bad debts will be very high.
However, the bank may have to relax the condition of security in order to comply with the economic policy of the government.
Related: Essential Steps of Loan Documentation Procedure.
7. Margin Money
In the case of secured loans, the bank should carefully examine and value the security.
There should be a sufficient margin between the number of loans and the value of the security.
If an adequate margin is not maintained, the loan might become unsecured in case the borrower fails to pay the interest and return the loan.
The amount of loan should not exceed 60 to 70% of the value of the security. If the value of the security is falling, the bank should demand further security without delay.
In case a person fails to do so, the loan might become unsecured and the bank has to suffer a loss on account of bad debt.
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8. National Interest
Banks were nationalized in India to have social control over them.
As such, they are required to invest a cetin percentage of loans and advances in priority sectors, viz, agriculture, small scale, and tiny sector, and export-oriented industries, etc.
Again, the Reserve Bank also gives directives in this respect to the scheduled banks from time to time.
The banks are under obligation to comply with those directives.
9. The Character of the Borrower
last but not the least, the bank should carefully examine the character of the borrower.
Character implies honesty, integrity, creditworthiness, and capacity of the borrower to return the loan.
In case a person fails to verify the character of the borrower, the loans and advances might become bad debts for the bank.
Conclusion
Banks lend money as term loan when the repayment is sought to be made in fixed, predetermined installments.
This type of loan is normally given for acquiring long term assets, namely, assets will benefit the borrower over a long period (exceeding at least one year).
Financing for purchases of plant and machinery, constructing buildings for factories, setting up new projects purchasing automobiles and consumer durables, real estate, and creation of infrastructure all fall in this category.
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