Lending is regarded as core function of banking institutions. The banks accept deposit from general public and lend that raised money to needy peoples in the form of loan, overdraft, advances and cash credit. A good amount of interest is earned on these lending’s that serve as main source of income to banks. However, prior to providing loans, a bank should properly evaluate the credit worthiness of borrower, security provided against loan and purpose for which loan is being taken. Some basic principles should be necessarily followed by bank at time of lending, in order to ensure their smooth and long-term functioning without any interruption. The sound principles of lending are: –
Safety of Principal
It is first and foremost principal of sound lending in order to ensure the safety of money lend to public. This helps in knowing whether borrower is in a position to repay loan amount along with interest accrued on it, as per the terms and conditions of loan contract. Repayment of loan is majorly dependent upon two factors: Borrower’s capacity to pay and borrower’s willingness to pay.
Therefore, a banker should take proper care for ensuring that organization or business to which loan is being granted is sound one and borrower is capable to pay back the loan amount successfully.
Liquidity or Marketability
Liquidity of loans is considered as another major principle of good lending practices. The term ‘liquidity of loans’ here denotes the quick realisation of loans from borrowers. Money is generally lent by bank for short time-periods only as they provide loans using the public money (money accepted as deposits from public) that can be withdrawn by depositors at any point of time. This is the reason that bank provide loans on security of those assets that can be easily converted in to cash at short notice. A banker should therefore check if borrower is able to pay back the loan on demand or at short notice.
The commercial banks are not charitable units but are profit making institutions. Banks need to earn profit for paying interest to depositors, salaries to staff, dividends to shareholder, establishment expenses and for meeting their day-to-day expenditures. Therefore, they should employ their funds in a profitable manner so as to earn sufficient income for doing all these payments on timely basis. A sound principle of lending does not sacrifice safety and liquidity for the sake of making high profits.
The inclusion of risk element in loan and advances cannot be totally eliminated but can only be reduced to a certain level. Diversifying the loans works effectively toward reducing the risk involved in loan. Bank should never grant a major portion of loan to one single borrower or particular business enterprise. Instead, they should grant loans and advances to number of peoples, businesses or industries. This way bank will not suffer any heavy losses, in case, if any of the borrower does not repay loan amount.
Purpose of Loan
The purpose of loan should be clarified by banker at the time of granting loan. A borrower will not throw away money for any purpose for which borrower wants. If the loan is meant for productive purposes, then there are high chances that borrower will make much profit and will be able to repay loan amount successfully. Whereas, if loan is for unproductive purposes, then money will not be safe as there are low chances of loan repayment.
The security provided by borrower for advance taken act as an insurance to bank. At the times of unforeseen emergency, this security serves as safety valve. Security offered against loan and advances can be distinct types such as plot of land, flat, building, term deposits, insurance policies etc. A banker must realize that security work like a cushion to fall back upon in case of need. Also, it should be considered that security accepted against advances must be adequate, readily marketable, free from encumbrance and easy to handle. It is therefore, the duty of banker to examine the nature of security and access if it is right for loan granted.
Margin money refers to difference in between the amount of loan and value of security. The security value should be carefully examined by banks, in case of secured loans. A secured advance is one that is made on the security of either assets or against personal guarantee. On the other hand, an unsecured advance is one that is not secured. There should be sufficient margin in between the loan amount of value of security. If margin maintained is not adequate, then loan may become unsecured, in case if borrower fails to return the loan and pay interest.
The banks carry certain social responsibilities towards society also. Beside safety, liquidity and profitability, the banks also need to consider economic and social priorities of country as well. Banks are guided by governmental policies with regard to credit disbursal, at the time of formulating their lending policies. Therefore, the lending decisions of banking institutions are getting influenced by national interest and policies.
Saleability of securities
Further, the funds should be invested by banks in such securities that can be easily marketed during emergencies. A bank cannot afford to put its funds in unsaleable or long-term securities. It is must for bankers to do investment in first class or government securities or in debentures of reputed companies. In addition to this, loans should also be granted against those stocks that can be easily sold.
Stability in value of investments
The bank should give more priority towards doing investments in stocks and securities that are more stable. A bank cannot afford to put its funds into securities whose prices are subject to frequent fluctuations as it can bring heavy losses for it.
At last, it can be said that that due consideration of above-mentioned principles is necessary for banking companies, at the time of evaluating loan proposal for avoiding risky options.