Principles of sound lending

Traditionally, banks have been following three cardinal principles of lending, viz. safety, liquidity and profitability. Banks in India have shouldered additional responsibility of fulfilling social obligations. Hence, the banks observe both the traditional and certain other principles.

  1. Safety – safety first as advocated by Tannon should be the guiding principle. A bank lends what it receives from the public as deposits. The success of any bank depends upon the confidence of the depositing public. Confidence could be infused in the depositors by investing the money in safe and sound securities. Safety depends upon (a) the security offered by the borrower and (b) the repaying capacity and willingness of the debtor to repay the loan with interest. So, the banker should ensure that the security offered are adequate and readily realizable and the borrower is a person of integrity, good character and reputation.
  2. Liquidity – Liquidity refers to the ability of an asset to be converted into cash without loss within a short time. The liabilities of a bank are repayable on demand or at a short notice. To meet the demand of the depositors in time, the banks should keep its funds in liquid state. Money locked up in long-term loans such as land, building, plant, machinery, etc., cannot be received back in time and so les liquid. Short term loans and loans granted against securities such as goods can be converted into cash easily and so liquid. So, a bank should confine its lending to short-term against marketable securities.
  3. Profitability – like all other commercial institutions, banks are run for profit. Even government-owned banks are no exceptions to this. Banks earn profit to pay interest to depositors, declare dividend to shareholders, meet establishments charges and other expenses, provide for reserve and for bad and doubtful debts, depreciation, maintenance and improvements of property owned by the bank and sufficient resources to meet contingent loss. So, profit is an essential consideration. A banker should employ his funds in such a way that they will bring him adequate return. The main source of profit comes from the difference between interest received on loans and those paid on deposit. Anyway, a banker should never give undue importance to profitability.
  4. Security – Customers may offer different kinds of securities, viz. land, building, machinery, goods and raw material to get advances. The securities of the customers are like insurance to fall back upon them in times of necessity. For the sake of safety, he should ensure that the securities are adequate, marketable and free from encumbrances. Securities which could be marked easily, quickly and without loss should be preferred.
  5. Purpose of the loan – Before sanctioning loans, a banker should enquire about the purpose for which it is needed. Loans for undesirable activities such as speculation and hoarding should be discouraged. Borrowings for productive purposes are readily allowed by banks. It is also equally important on the part of banks to ensure that a loan is utilized for the purpose for which it is granted so that repayment will be prompt. In many countries central bank gives directions as to the purpose for which loan may be made. Section 21 of Banking Regulation Act 1949 confers on Reserve Bank of India the power to control advances by banks.
  6. Sources of Repayment – Before giving financial accommodation, a banker should consider the source from which repayment is promised. In some instances, debentures which are to be redeemed in few months time or a life policy which is to mature in near future may be offered as security. An advance against such security gives no trouble. Sometimes, customers may apply for loans for additional working capital for their business and undertake to repay out of the profits over a period. In such cases, the rate at which the customer can reasonably hope to repay should be ascertained. An examination of the audited accounts may guide the banker in knowing the repayment capacity of the customer.
  7. Diversification of risks – The security consciousness of a banker and the integrity of the borrower are not adequate factors to keep the banker on a safe side. What is more important is the diversification of risk. This means he should not lend a major portion of his loanable funds to any single borrower or to an industry or to one particular region. An adverse change in the economy of these may affect the entire business. In such a case repayment will be highly difficult and the survival of the bank becomes questionable. Therefore, a bank should follow a wise policy of ‘do not lay all the eggs in the same basket’. The bank must advance moderate sums to a large number of customers spread over a wide area and belonging to different industries and different strata of society.
  8. Recent concept of sound lending – Productivity of the loan: In the wake of nationalization of the 14 banks, banking has undergone a metamorphosis. Today, a bank is not exclusively a financial institution but is alive to the needs of the people. It has a strong social objective and social conscience. Banks are catalytic agents in catering to the better needs of development in conformity with the national objectives. If rapid progress is to be realized, bank credit should be made available to the neglected sectors of economic activity and to the underprivileged sections of the society. To make this a reality, banks have to shed their outlook of security consciousness. The traditional belief of security being the measurement of credit needs is a myth.
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