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A banker follow certain basic principles of lending while doing carrying out their lending and credit operations. Banks deals with public money accepting deposit and lend to their borrowers to earn profit. Banks follow some fundamental principles of lending in order to ensure safety, security and profitability on money it lend. Lending is one of the most important functions performed by the commercial banks and is major source of income of bank.
Borrower may differ in terms of their purpose of advance, activities, financial health, repayment capacity, risk so some important principles / considerations are followed by bank before taking lending decision.
Important Principles of Lending in Banking | Credit Principles
These basic principles of bank lending affect bank’s loan policies, credit operations to a great extent. Here are some important principles of lending :
- Diversity or Risk Spread
Safety is the most important fundamental principle of lending. Banks deal with public money so safety of money from public is first priority of bank. When a banker lends, he must be sure about that the money is in safe hand and will definitely come back at regular interval as per repayment schedule without any default. Safety of funds depends on nature of security, character of borrower, repayment capabilities and financial health of the borrower.
A banker must ensure that finance extended by him goes to right type of borrower and is being used for the intended purpose. And also after utilizing it for right purpose it should be repaid with interest.
Liquidity is also an important principle of lending in banking. Bank lend public money which is repayable on demand by depositors so bank lends for a short period. A banker must ensure that money will come back on demand or as per repayment schedule. The borrower must be able to repay the loan within a reasonable time after demand for repayment is made.
‘Liquidity’ has as much importance as ‘safety’ of funds. The reason behind it is that a bulk of their deposit is repayable on demand or at a very short notice. Banker must ensure that money is locked up for a long time. If loan becomes illiquid, it may not be possible for bankers to meet their obligations vis a vis depositors.
The underlying purpose for which an applicant is seeking a loan should be productive. The purpose of loan helps in determining level of risk and also impact interest rate on loan.
Purpose of loan should be productive in order to ensure safety of funds while it should be extended for short term to ensure liquidity.
Diversity / Risk Spread
Do not put all eggs in one basket – Bank follow this approach (principle of diversity) while creating its advances portfolio. Risk is always present while extending any kind of advance to any type of borrower. To minimize the risk, bank should lend to borrowers from different trades, industries like agriculture, education, IT, pharma, educational etc. Lending surplus to a particular sector may have adverse affect on bank in time of slump.
A banker must follow principle of diversity also while choosing its investment portfolio. He must invest the funds over different share and debentures of different industries rather than investing in particular type of security.
Banks accept deposits from public and lend it to make profit. Banks also incur expenses to maintain deposits such as rent, stationary, premises rent, provision for depreciation of their fixed assets, bad loans. After incurring such expenditures, a bank must earn some profit like other financial institutions.
So a banker must extend the advance in such a way that it is profitable for bank and also at competitive lending rate.
A banker avoid lending to a borrower without any security. Security act as an insurance to lender bank in case of default by the borrower. The banker carefully scrutinizes all the different aspects of an advance before granting it. At the same time, he provides for an unexpected change in circumstances which may affect the safety and liquidity of the advance. It is only to provide against such contingencies that he takes security so that he may realize it and reimburse himself if the well-calculated and almost certain source of repayment unexpectedly fails.
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