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 individual

5 Cs of Process
safety Security the
liquidity Appraisal of
diversity stability profitability borrower 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money which can be withdrawn at any time by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 banks 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 Cs 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.
 Forms of mortgage
Simple Mortgage
Mortgage by condition sale
English Mortgage
Mortgage by deposit of title deed or equitable
mortgage
Anomalous mortgage
 Difference Between Pledge, Hypothecation and
Mortgage

Pledge Hypothecation Mortgage

Type of Security Movable Movable Immovable

Possession of the Remains with lender Remains with Usually Remains with
security (pledgee) Borrower Borrower

Gold Loan, Advance

against NSCs, Adv Car / Vehilce Loans,
Examples of Loan
against goods (also Adv against stock and Housing Loans
where used
given under debtors
hypothecation)
 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 less
Foreign banks with 20 and above than 20 branches (As
branches (As percent of ANBC or percent of ANBC or Credit
Credit Equivalent of Off-Balance Equivalent of Off-Balance
Sheet Exposure, whichever is Sheet Exposure, whichever
higher) is higher)
Total Priority Sector 40 32

Total agriculture 18 No specific target.

Advances to Weaker 10 No specific target.

Sections
 '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 banks
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 RBIs 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