Loans and Advances

Loans and Advances

Banking business primarily involves accepting deposits from the public and investing or lending the same and thereby making profit out of it. However, lending money is not without risk and therefore banks make loans and advances to farmers, traders, businessmen and industrialist against either tangible (land, building, stock etc.) or intangible security. Even then, the banks run the risk of default in repayment. Therefore, the banks follow cautious measures while lending money to others.

Considerations for sound lending

While lending money the banker has to take into account various considerations. These considerations relate to the bank itself, the borrower, and the proposal.

Considerations about the Bank itself

The bank while lending money should look to its position regarding liquidity, safety and profitability.

(i) Liquidity: Since banks themselves heavily depend on borrowed funds, they arrange their investment portfolio in such a way that they are in a position to acquire cash within a short period of time. Their borrowings also come from deposits which are usually not for a very long period. The banks, therefore, prefer granting of short-term loans to their customers.

(ii) Safety: The capacity of the banker to repay money to its depositors depends upon its borrower’s repaying capacity. The banker has, therefore, to see the safety of the advances made by it.

(iii) Profitability: The banker earns its profits mainly through advances and, therefore it cannot ignore the consideration of profitability while making advances. However, the bank cannot ignore the other two aspects too. It has to see that the funds remain fairly liquid, safe and give a reasonable return. In order to have a proper balance, the bank keeps in its investment portfolio three types of investments-liquid, semi-liquid and income earning investments. It has to maintain them in optimum proportions.

 

Considerations about the Customer:

The banker while selecting his borrower should have a clear appraisal about the three C’s-Character, Capacity and Capital. Character denotes integrity of the borrower i.e. he should have willingness to repay the money borrowed. Capacity denotes the ability to manage his business. The bank can judge it on the basis of the educational background and the experience of the entrepreneur. Capital denotes his financial soundness. The borrower should lave some funds of his own also. No banker will like to lend money to a person who does not put money from his own sources. It may be difficult to find a borrower who has all these three qualities. However, the banker should see that he does not lack any of them in a significant way.

Considerations about the Proposal

The bank should look to the following aspects regarding the proposal.

(i) Purpose: The purpose for which the money is being borrowed is gaining more importance on account of increasing realization on the part of the banks about their social responsibility. The project which will help in rural upliftment, import substitution or equitable distribution of income has to be preferred in comparison to other projects. Similarly loans for productive purposes should be given in priority to loans for unproductive purposes, such as for marriage or other religious ceremonies.

(ii) Security: Security is now considered to be a secondary consideration while advancing loans. However, the aspect cannot be completely overlooked since it is a safeguard for unexpected defaults in repayments by the borrower.

(iii) Sources or repayment: The banker has also to see whether the project for which it is lending money will generate necessary cash to repay the loan and the interest as per the agreed program.

(iv) Term: The term or the period for which the loan is required is also important. Banks cannot afford to lock up their funds for long periods. They, therefore, prefer granting of short-term loans to long-term loans.

FORMS OF ADVANCES

The advances made by the commercial banks may be classified into the following categories.

(i) Loans

(ii) Cash credits

(iii) Overdrafts.

(iv) Bills discounted and purchased.

Loans

A loan is a kind of advance made with or without security. In the case of a loan the bank makes a lump sum payment to the borrower or credits his deposit account with the money advanced. It is given for a fixed period at an agreed rate of interest. Repayments may be made in instalments or at the expiry of a certain period. The customer has to pay interest on the total amount advanced whether he withdraws the money from his account (credited with the loan) or not. A loan once repaid in full or in part cannot be withdrawn again by the borrower unless the banker sanctions a fresh loan.

Banker can charge a lower rate of interest in the case of loans than cash credits and overdrafts on account of the following reasons :

(i) It involves lower cost of maintenance as the accounts are not operated very frequently.

(ii) The bank gets interest on the total amount sanctioned whether the customer withdraws the whole money or not.

Loan may be a ‘term loan’ or a ‘demand loan’. Term loan’s payment is spread over a long period. It includes a medium term loan (repayable within 3 to 5 years) and a long term loan (repayable after 5 years). Demand loan is payable on demand. Thus, it is for a short period.

Cash Credits

A cash credit is an arrangement by which a banker allows his customer to borrow money up to a certain limit. Cash credit arrangements are usually made against the security of commodities hypothecated or pledged with the bank. In this case, the customer need not borrow at once the whole of the amount he is likely to require but draw such amounts as and when required. He can put back any surplus amount which he may find with him for the time being. Interest has to be paid by the customer on the amount actually drawn at any time and not on the full amount of the credit allowed.

However, cash credit system runs with some limitations. Here the banker lays greater emphasis on the security offered rather the end-use of funds. As a result the funds are diverted to other purposes without banker’s knowledge. Besides, this system it is not the banker but the borrower who decides when and how much he will borrow. In other words utilization of credit limits depends upon the discretion of the borrower.

Overdrafts

The customer may be allowed to overdraw his current account, with or without security if he requires temporary accommodation. This arrangement, like the cash credit, is advantageous from the customer’s point of view as he is required to pay interest on the actual amount used by him. A cash credit differs from an overdraft in the sense that the former is used for long-term by commercial and industrial concerns doing regular business, while the latter is supposed to be a form of bank credit for occasional use and for shorter duration.

Bills discounted and purchased

The bank also give advances to their customers by discounting their bills. The net amount after deducting the amount of discount is credited to the account of the 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 persons already liable on the bill.

Secured and Unsecured Advances

Advances may be secured or unsecured. A secured advance means:

(i) an advance made on the security of tangible assets like goods, building, stock exchange securities etc., and

(ii) the market value of such security must not be less than the amount of loan at any time till the loan is repaid. An unsecured loan or advance means a loan or advance not so secured.

In case of secured loan, charges are created in favor of the bank in respect of the properties offered as security. In case of an unsecured loan usually the banks obtain the guarantee of one or more parties in addition to personal security of the debtor. Unsecured loans without any guarantee i.e. clean advances, are granted by banks to parties enjoying high reputation and should financial position.

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