Lending of money by Banks and Its principles
Lending money is one of the primary functions
of the bank. Lending of funds to individuals, traders, businessmen and
industrial enterprises, is one of the important activities of commercial banks.
Interest earns on these loans and advances are the major source of income of
the banks. Interest given on deposits is lower than the interest received on
such loans and advances. Amount deposited by the customers forms the main
source of loans and advances.
Various
types of loans and advances given by banks: Banks lend money in various forms for
various purposes which are given below:
1) Cash
Credit: Cash Credit is a type of advance wherein a banker permits his customer
to borrow money upto a particular limit by a bond of credit with one or more
securities. The advantage associated with this system is that a customer can
withdrawn money as and when required. The bank will charge interest only on the
actual amount withdrawn by the customer. Many industrial concerns and business
houses borrow money in this form.
2) Overdraft:
An overdraft is an arrangement by which the customer is allowed to overdraw his
account. It is granted against some collateral securities. The facility to
overdraw is allowed through current account only. Interest is charged on the
exact amount of overdrawn subject to the payment of minimum amount by way of
interest.
3) Loan: Loan
is an advance in lump sum amount the whole of which is withdrawn and is
supported to be rapid generally wholly at one time. It is made with or without
security. It is given for a fixed period at in agreed rate of interest.
Repayments may be made in installments or at the expiry of a certain period.
4) Discounting
Bill of Exchange: The bank also gives advances to their customers by
discounting their bills. The net amount after deducting the amount of discount
is credited to the account of customer. The bank may discount the bills with or
without any security from the debtor in addition to the personal security of
one or more person already liable on the bill.
Difference between Loan, Cash Credit and Overdraft:
|
Basis of
Differences
|
Loan
|
Cash Credit
|
Overdraft
|
|
1.
Mode
|
A
loan may be given in cash or by credit to the account of the borrower.
|
Cash
credit is always given through the current account.
|
Overdraft
is granted to the current account holders.
|
|
2.
Borrower
|
The
borrower of loan may be a customer of the bank or otherwise.
|
The
borrower of cash credit becomes customer of the bank when he open the current
account.
|
An
existing customer having current account is granted over draft facility by
the bank.
|
|
3.
Security
|
A
loan may be granted against tangible securities or personal guarantee of the
borrower.
|
Cash
credit is always given against some tangible securities.
|
Overdraft
may be clean, partly secured or fully secured.
|
|
4.
Interest
|
Interest
is charged on the entire amount of loan.
|
Interest
is payable only on the amount actually utilised by the borrower.
|
Interest
is payable on the amount overdrawn from the current account.
|
|
5.
Rate of interest
|
The
rate of interest charged by the bank in case of loan is lower than that of
the cash credit and overdraft.
|
The
interest rate in case of cash credit is higher than that of the loan and
overdraft.
|
The
rate of interest in case of overdraft is higher as compared to loans but
lower than cash credit.
|
|
6.
Maturity
|
A
loan has a specific maturity date and is repayable after a fixed period to
time.
|
Cash
credit do not have a fixed maturity date and it is technically repayable on
demand.
|
Overdraft
is repayable on demand and do not have any maturity date.
|
|
7.
Period of advance
|
A
loan may be taken by the borrower for short, or medium or long period of
time.
|
Cash
credit may be obtained for short, medium or long period of time.
|
Overdraft
is a short term temporary arrangement.
|
|
8. Number of withdrawals
|
In
case of loan, funds are withdrawn once be the borrower.
|
In
case of cash credit funds are withdrawn number of times by the borrower.
|
In
case of overdraft, funds are withdrawn number of times.
|
The
principles of sound lending by commercial banks are: Banks
should follow some basic principles at the time of lending. This ensures
efficient and long term working of
the banks. Some of the basic principles of lending are as follows:
1) Safety of
principal: The first and foremost principle of lending is to ensure the safety
of the funds lent. It means that the borrower is in a position to repay the
loans, along with interest, according to the terms of the loan contract. The
repayment of the loan depends upon the borrower’s (i) capacity to pay and (ii)
willingness to pay. The banker should, therefore, take utmost care in ensuring
that the enterprise or business to which a loan in to be granted is a sound one
and the borrower is capable to repay it successfully.
2) Profitability:
Commercial banks are profit earning institutions. They must employ their funds
profitably so as to earn sufficient income out of which to pay interest to the
depositors, salaries to the staff and to meet various other establishment
expenses and distribute dividends to the shareholder. The sound principle of
lending does not sacrifice safety or liquidity for the sake of higher
profitability.
3) Marketability
or Liquidity: Liquidity of loans is another principle of sound lending. The
term liquidity of loan indicates quick realisation of loans from the borrowers.
Banks are essentially dealers in short term funds and therefore, they lend
money mainly for short term period. The banker should see that the borrower is
able to repay the loan on demand or within a short notice.
4) Purpose of
the loan: Before granting loans, the banker should examine the purpose for
which the loan is demanded. If the loan is granted for productive purpose,
thereby the borrower will make much profit and he will be able to pay back the
loan. In no case, loan is granted for unproductive purpose.
5) Diversification:
The element of risk in relation to loans cannot be totally eliminated, it can
only be reduced. Risks of lending can be reduced by diversifying the loans.
While granting loans, the banker should not grant a major part of the loan to
one single particular person or particular firm or an industry. If the banker
grants loans and advances to a number of firms, persons or industries, the
banker will not suffer a heavy loss even if a particular firm or industry does
not repay the loan.
6) National
policies: Banks have certain social responsibilities towards society also. The
banks have to take into account the economic and social priorities of the
country beside safety, liquidity and profitability. While formulating the
lending policy, the banks are guided by the government policies in relation to
disbursal of credit. Thus, national interest and policies are influence the
lending decisions of banks.
In conclusion, it may be said that due consideration
of all the principles are necessary, while evaluating a loan proposal.