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Cardinal Principles Of Lending

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  • Pages: 8
  • Word count: 1963
  • Category: Bank Debt

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A bank is an institution which is primarily seen as a body that accepts monetary deposits from its customers (general public), looks after their money, offer them some beneficial services such as cheque books to make payments and lends money to other public (borrowers). Now lending money to someone comes with some inherent risks especially when a bank uses its depositors’ money to lend. To put it simply a bank’s major operation is to borrow money from depositors and lend money to different kind of borrowers. Since the primary source of funds for a bank is its depositors’ money which are repayable as and when demanded by the depositors, it is extremely important for a bank to be cautious while lending money to customers.

Therefore, the banker should follow the cardinal principles of lending while lending money and make sure all the norms of sound financial lending are practised. To put it simply banks make money by lending money to borrowers, so it becomes very important for banks to follow the cardinal principles of lending. When these principles are followed, they ensure the safety of banks’ funds and that in turn provides assurance to its depositors and shareholders. In the process, banks also make profits and grow as financial institutions. Sound lending principles by banks, can also help the economy of a country to grow and promote expansion of banking habit in rural areas. The cardinal principles of lending are as follows:

A. Safety
B. Liquidity
C. Profitability
D. Purpose
E. Diversification of risks
F. Security
We would now discuss about each of the principles in details. A. Safety:
The most important principle of sound lending is safety. The banker, while lending, has to ensure that the loan is provided to the right depositors who would repay the amount with due interest and make the payment on time. It is the banker’s duty to ensure that the money lent remains safe and comes back to the back ultimately. Safety is the first and foremost principle. By safety we mean that the borrower is in a position to repay the loan, with due interest, as per the terms and conditions of the contract of the loan. The repayment of the loan depends on many things however it largely depends on the a) borrower’s capacity to pay and b) his willingness to pay. The borrower’s capacity to repay depends on many factors. For example, if a bank is lending money to a businessman, the repayment of the loan depends on how successful the borrower is in his endeavour.

If the businessman becomes successful is his efforts, he can earn profit and repay the loan. But if his business does not become successful, the money can be recovered by the bank by selling of his tangible assets. Therefore, the banker should take utmost care in ensuring that the businessman or enterprise for which the loan will be sanctioned is capable enough to repay the loan. To check the borrower’s capability to pay, the banker largely needs to look at two things: borrower’s purpose of taking a loan and how sound is the purpose and his tangible assets. To make sure the willingness part, the banker needs to ensure that the loan is sanctioned for borrowers who have integrity, good character and reputation. On top of this, the bank also relies on tangible assets to ensure the safety of its funds.

B. Liquidity:
Another important principle of sound lending is liquidity. It has been observed that about 70% of depositors’ money are repayable within a year, so the banks should always ensure that there is enough liquidity and cash available with them to be able to repay the depositors as and when the demand arises. Banks are generally there for short term funds and they lend funds for short term projects or working capital related purposes. And as we all know these loans are payable on demand. The bankers must ensure that the borrowers are capable of to repay the loan on demand or within a short period of time. This is primarily the reason why banks put so much importance on the borrowers’ assets that are pledged to the banker. For example, if a borrower has taken loan to invest in his commodity and goods business, it can be expected that the assets could be liquidated soon and the borrowers will be able to repay the loan within a short period of time.

While loans given for fixed assets such as land or building will take some time to be liquidated and hence the borrower will need some time to repay the loan. Assets such as land, plant equipment can be liquidated after a certain time interval. This is the reason why banks consider liquidity as one of the important principles and sanction loans on security of assets that are easily marketable or can be liquidated easily. Sometimes, banks consider liquidity as important as safety of funds. Generally banks avoid term loans which are beyond three years.

C. Profitability
Banks are profit making institutions. Even nationalized banks such as SBI, BOI, etc. are no exceptions. Banks need to ensure they use their funds properly to earn profit so that they can repay the depositors, pay salaries to their employees and pay dividends to their shareholders. The nationalized banks share their profits with the government of India. Banks also need additional funds for other purposes such as to expand its businesses, opening new branches, introducing new services and products. Banks generally charges a higher rate of interest to its borrowers than what they pay to its depositors. The additional interest generally contribute to its profits. Earlier the lending interest was heavily regulated by the central bank.

But now banks have enough freedom to decide upon on their interest rates (albeit within certain norms). The interest rate that banks generally charge to the borrowers depends on the degree of risks involved in lending to them. Generally a customer with high reputation will have to pay lesser interest rate compared someone who is unknown and presumed to be an ordinary borrower. Though profitability is important, but it not more important than safety or liquidity. The cardinal principles say that banks should not grant loans to unsound customers even when they are ready to pay high amount of interest rates. Such lending could be irrecoverable and can be detrimental.

D. Purpose
Banks never lend money that will lead to loose of money. The main reason of lending loans is to use the money for productive purpose. Bank advances for the safety of its money and guarantee of recovery of loan. Therefore before approving a loan, bank ensures the purpose of lending and its use in productive way. Banks do not grant loans for each and every purpose – they ensure the safety and liquidity of their landings for productive use only. An example would be meeting working capital needs of a business enterprise.

Loans are not given for reasons like speculative and not productive reasons. Here the example would be loans are not granted for purpose like holiday/pleasure trips, repayment of previous loans, social function and ceremonies etc. Industries need long term loans for capital investment, hence they also approach banks. Banks also grants such term loans for long term loans. After the major change in the banking industry which is also termed as Nationalisation of banks lead to approving loan for small traders. Banks started granting loan for initial expenditure to start small scale industries and business. E. Diversification of Risk:

It is also an important part of cardinal principle of sound lending. A judicious banker always tries to select the borrower very tactfully and carefully. It also takes tangible assets as securities to save its interests. However, tangible assets are not that valuable and banks has to take some amount of risk while granting advances and lending on the securities of such assets. Any industry at times like economic downturn may face depressionary situation and simultaneously the prices of goods and services may fall sharply. It may also face such disturbances during natural calamities, political instability. These unfortunate and uncertainty situations bring prosperous business down and also have capability to ruin the entire business. To safeguard against such activities, banks follow principle of risk diversification. So bankers not only concentrates on big loans or big firms it also tries to distribute the total wealth into various sectors, industries and among various sizes. Its horizon gets wider and hence the risk gets lower.

It follows the famous saying “Do not keep all eggs in one basket”. A bank should be very careful while lending loans because if the bank lends to a non-creditworthy customer, it will affect the survival of the bank. To diversify the lending risk they should lend loans to customers from different sectors such as agriculture, housing, educational, etc. Concentrating on a particular set of customers will adversely affect the bank. If a big customer is hit by economic instability then the overall position of bank will not be affected. The lending should be spread across the various industries, various form of investment, various form of trades in different geographical location. F. Security:

Security of funds advanced is one of the most important cardinal principles of lending. Security of safety means the borrower is able to repay the loan and pay the interest in regular interval of time without default. The repayment of loan and advances depends on the nature of security, financial standing of borrower and his ability to payback. It also depends on characteristic of the borrower. Banks lend their money to borrowers from whom it can expect high degree of stable return. They must have policy to invest their wealth in shares and stocks those possess high degree of price stability. The banks cannot bear to make loss on any of its securities. So banks tend to invest in reputed firms whose market price reductions are remote. Govt. bonds and debentures are more stable in comparison to stocks of firms. Interest rate from Govt. bonds and debenture are very much in line with market rate of interest. They change with the market rate of interest. So banks investing in govt. bond and debenture are not affected by market rate of interest.

Central govt. security funds are more secure than those of state govt. and local bodies. The security of state govt. and local bodies are safer than those of industrial concerns. The main reason behind this is the resources of central govt. is highest compared to the resources of state govt. and local bodies. The industrial projects have limited resources hence their securities have least stability compared to earlier ones. From banks point of view, the nature of security is most important parameter while considering a loan. Even then bank has to make policy which enables them to check creditworthiness of borrower. Creditworthiness is governed by his character, ability to repay and current financial standing. Above all safety of banking funds mainly depends on upon the technical feasibility and economic viability of project and industry for which loan has been advanced.

In an economy, banking industries are at the highest commanding position among all the industries. Their policies and objectives should be in line with the policy and objective of nation. Twenty odd banks have been nationalised to server the nation. After this significance change in the banking industry banks have changed their view towards weaker section of economy. Banks have directed to finance on large scale agriculturist, small scale industries, personal financing etc. The Credit Guarantee Corporation and Deposit Insurance provides guarantee for such loans. To conclude, we can say that bank credit has to act as a major instrument for achieving wider social purpose, national policies and objectives.

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