Principles of lending

Principle of lending

• The business of lending, which is main business of the banks, carry certain inherent risks and bank cannot take more than calculated risk

• whenever it wants to lend. Hence, lending activity has to necessarily adhere to certain principles.

• Lending principles can be conveniently divided into two areas (i) activity, and (ii) individual.

lending

Activity

liquidity

diversity

stability

profitability

safety

individual

Security Apprais

al

5 ‘C’s of the

borrower

Process of

Lending

liquidity• Liquidity is an important principle of bank lending. Bank lend

for short period only because they lend public money which can be withdrawn at any time by depositors.

• They therefore advances loans on security of such assets which are easily marketable and convertible into the cash at short notice.

• A bank chooses such securities in its investment portfolio which possess sufficient liquidity. It is essential because if the bank needs cash to meet the urgent requirement of its customers, it should be in position to sell some of the securities at a very short notice without disturbing their market prices much.

• There are certain securities such as central, states and local govt. bonds which are easily saleable without affecting the price of market

safety• The safety of funds lent is another principle of

lending. • Safety means that the borrower should be able to

repay the loan and interest in time at regular intervals without default.

• The repayment of the loan depend upon the nature of the security, character of the borrower, his capacity to repay and his financial standing.

• Like other investment bank investments involves risk but the degree of risk varies with the type of the securities of the central govt. are safer than those of the state govt. and local bodies.

diversity• In choosing its investment portfolio a commercial

bank should follow the principle of diversity.• It should not invest its surplus funds in a particular

type of securities. It should choose the shares and debentures of different types of industries situated in different regions of the country. The same principle should be followed in the case of state govt. and local bodies.

• Its aim at minimizing risk of the investment portfolio of a bank. it also applies to the advancing of loans to varied types of firms, industry, business and trades.

• “ Do not keep all eggs in one basket ”

stability• Another important principle of bank’s investment policy

should be to invest in those stocks and securities which possess a high degree of stability in their price.

• The bank cannot afford any loss on the value of its securities. It should therefore invest it funds in the shares of reputed companies where the possibility of decline in their prices is remote. Govt. bonds and debentures of companies carry fixed rates of interest.

• Their value change with change in the market rate of interest. But the bank is forced to liquidate a portion of them to meet its requirement of cash in cash of financial crisis.

• Otherwise they run to their full term of 10 years or more and change in the market rate of interest do not affect them much. Thus banks investments in debentures and bonds are more stable than in the shares of the companies.

profitability• This is the cardinal principle for making investment by a

bank. Its must earn sufficient profits.• It should therefore invest in such securities which was sure

a fair and stable return on the funds invested. • The earning capacity of securities and share depends upon

the interest rate and the dividend rate and the tax benefits they carry.

• It is largely the govt. securities of the centre, state and local bodies that largely carry the exemptions of their interest from taxes.

• The bank should invest more in such securities rather than in the shares of new companies which also carry tax exemption. This is because shares of new companies are not the safe investment.

Secured Advances

• Cardinal principle of sound banking is to ensure safety of funds lent by banker to his customers.

• The banker therefore relies on primarily on the 3 C’s of borrower.

• Secured advances are those advances which provide absolute safety to the banker in means of charge created on the tangible assets of the borrower in favor of the banker.

Modes of creating charge : Lien

• Section 171 of the Indian Contract Act confers the right of general lien on the banker.

• The banker is empowered to secure all securities of the customers, in result of the general balance due from him.

• The ownership of stock securing is not transferred from the customer to the banker.

Negative Lien • The borrower gives a declaration to the banker

that his assets mentioned therein are free from any charge or encumbrance.

• He also gives an undertaking that he shall not create any charge or dispose them off without permission of the banker.

• The borrower cannot dispose of the assets or create any charge there on without the consent of the banker.

PLEDGE • Sec. 172 of the Indian Contract Act – 1872 defines pledge as

‘bailment of goods as security for payment of debt or performance of a promise.

• Pledge is used when the lender (pledgee) takes actual possession of assets (i.e. certificates, goods ). Such securities or goods are movable securities. In this case the pledgee retains the possession of the goods until the pledgor (i.e. borrower) repays the entire debt amount. In case there is default by the borrower, the pledgee has a right to sell the goods in his possession and adjust its proceeds towards the amount due (i.e. principal and interest amount). Some examples of pledge are Gold /Jewellery Loans, Advance against goods,/stock, Advances against National Saving Certificates etc.

• The person who offer security is called – PLEDGER • To whom it is offered is called – PLEDGEE

HYPOTHECATION :• It is used for creating charge against the security of movable assets, but

here the possession of the security remains with the borrower itself.• Thus, in case of default by the borrower, the lender (i.e. to whom the

goods / security has been hypothecated) will have to first take possession of the security and then sell the same.

• The best example of this type of arrangement are Car Loans. In this case Car / Vehicle remains with the borrower but the same is hypothecated to the bank / financer.

• In case the borrower, defaults, banks take possession of the vehicle after giving notice and then sell the same and credit the proceeds to the loan account.

• Other examples of these hypothecation are loans against stock and debtors. [Sometimes, borrowers cheat the banker by partly selling goods hypothecated to bank and not keeping the desired amount of stock of goods.

• In such cases, if bank feels that borrower is trying to cheat, then it can convert hypothecation to pledge i.e. it takes over possession of the goods and keeps the same under lock and key of the bank].

MORTGAGE :• Sec. 58 of the transfer of property Act 1882 defines

mortgage as –• It is used for creating charge against immovable property which

includes land, buildings or anything that is attached to the earth or permanently fastened to anything attached to the earth (However, it does not include growing crops or grass as they can be easily detached from the earth).

• The best example when mortage is created is when someone takes a Housing Loan / Home Loan. In this case house is mortgaged in favour of the bank / financer but remains in possession of the borrower, which he uses for himself or even may give on rent.

• In this case transfer is called “MORTGAGOR” • Transferee is called – “MORTGAGEE”• Principle money & Int. thereon is called – “MORTGAGE MONEY”• Instrument is called – “MORTGAGE DEED”.

• Simple Mortgage• Mortgage by condition sale • English Mortgage • Mortgage by deposit of title deed or equitable

mortgage • Anomalous mortgage

Forms of mortgage

Difference Between Pledge, Hypothecation and Mortgage

  Pledge Hypothecation Mortgage

Type of Security Movable Movable Immovable

Possession of the security

Remains with lender (pledgee)

Remains with Borrower

Usually Remains with Borrower

       

Examples of Loan where used

Gold Loan, Advance against NSCs, Adv against goods (also given under hypothecation)

Car / Vehilce Loans, Adv against stock and debtors

Housing Loans

Priority Sector

• Priority sector refers to those sectors of the economy which may not get timely and adequate credit in the absence of this special dispensation.

• Typically, these are small value loans to farmers for agriculture and allied activities, micro and small enterprises, poor people for housing, students for education and other low income groups and weaker sections.

Categories under priority sector

• (i) Agriculture• (ii) Micro and Small Enterprises• (iii) Education• (iv) Housing• (v) Export Credit• (vi) Others

Targets and Sub-targets for banks under priority sector

Categories Domestic commercial banks / Foreign banks with 20 and above branches (As percent of ANBC or Credit Equivalent of Off-Balance

Sheet Exposure, whichever is higher)

Foreign banks with less than 20 branches (As

percent of ANBC or Credit Equivalent of Off-Balance Sheet Exposure, whichever

is higher)

Total Priority Sector 40 32

Total agriculture 18 No specific target.

Advances to Weaker Sections

10 No specific target.

'Direct Finance' for Agricultural Purposes

(i) Loans to individual farmers [including Self Help Groups (SHGs) or Joint Liability Groups (JLGs), i.e. groups of individual farmers] engaged in Agriculture and Allied Activities, viz., dairy, fishery, animal husbandry, poultry, bee-keeping and sericulture.

(ii) Loans to corporate including farmers' producer companies of individual farmers, partnership firms and co-operatives of farmers directly engaged in Agriculture and Allied Activities, viz., dairy, fishery, animal husbandry, poultry, bee-keeping and sericultureup to an aggregate limit of `2 crore per borrower.

(iii) Loans to small and marginal farmers for purchase of land for agricultural purposes.

(iv) Loans to distressed farmers indebted to non-institutional lenders.

(v) Bank loans to Primary Agricultural Credit Societies (PACS), Farmers’ Service Societies (FSS) and Large-sized Adivasi Multi Purpose Societies (LAMPS) ceded to or managed/ controlled by such banks for on lending to farmers for agricultural and allied activities.

'Indirect Finance' to Agriculture

(i) If the aggregate loan limit per borrower is more than `2 crore in respect of para. (4) (ii) above, the entire loan will be treated as indirect finance to agriculture.

(ii) Loans upto `5 crore to Producer Companies set up exclusively by only small and marginal farmers under Part IXA of Companies Act, 1956 for agricultural and allied activities.

(iii) Bank loans to Primary Agricultural Credit Societies (PACS), Farmers’ Service Societies (FSS) and Large-sized Adivasi Multi Purpose Societies (LAMPS).

Micro and Small Enterprises under priority sector

• Bank loans to Micro and Small Manufacturing and Service Enterprises, provided these units satisfy the criteria for investment in plant machinery/equipment as per MSMED Act 2006.

Manufacturing sector

Enterprises Investment in plant and machinery

Micro Enterprises Do not exceed twenty five lakh rupees

Small Enterprises More than twenty fivelakh rupees but does not exceed five crore rupees

Enterprises Investment in equipment

Micro Enterprises Does not exceed ten lakh rupees

Small Enterprises More than ten lakh rupees but does not exceed two crore rupees

Loan limit for education under priority sector

• Loans to individuals for educational purposes including vocational courses upto `10 lakh for studies in India and `20 lakh for studies abroad are included under priority sector.

limit for housing loans under priority sector

• Loans to individuals up to `25 lakh in metropolitan centres with population above ten lakh and `15 lakh in other centres for purchase/construction of a dwelling unit per family excluding loans sanctioned to bank’s own employees.

under Weaker Sections under priority sector

• Priority sector loans to the following borrowers are considered under Weaker Sections category:-

(a) Small and marginal farmers;(b) Artisans, village and cottage industries where individual credit limits do not exceed

`50,000;(c) Beneficiaries of Swarnjayanti Gram Swarozgar Yojana (SGSY), now National Rural

Livelihood Mission (NRLM);(d) Scheduled Castes and Scheduled Tribes;(e) Beneficiaries of Differential Rate of Interest (DRI) scheme;(f) Beneficiaries under Swarna Jayanti Shahari Rozgar Yojana (SJSRY);(g) Beneficiaries under the Scheme for Rehabilitation of Manual Scavengers (SRMS);(h) Loans to Self Help Groups;• (i) Loans to distressed farmers indebted to non-institutional lenders;• (j) Loans to distressed persons other than farmers not exceeding `50,000 per

borrower to prepay their debt to non-institutional lenders;• (k) Loans to individual women beneficiaries upto `50,000 per borrower;

The rate of interest for loans under priority sector

• The rate of interest on various priority sector loans will be as per RBI’s directives issued from time to time, which is linked to Base Rate of banks at present. Priority sector guidelines do not lay down any preferential rate of interest for priority sector loans