Introduction
Lending simply means to
loan out, advance, give offer etc. in banking operations lending is synonymous
to finance investment, funding, financial transaction, etc. Borrowing on the
other hand means an act of getting temporary possession of something, or is an
act of getting something on loan. In simple terms borrowing relates to the
person that obtains the loan while lending relates to the institution that
offers the loan.
Banks
follow the following principles of lending:
1.
Liquidity:
Liquidity is an
important principle of bank lending. Bank lend for short periods only because
they lend public money which can be withdrawn at any time by depositors. They,
therefore, advance loans on the security of such assets which are easily
marketable and convertible into cash at a 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 requirements of
its customers, it should be in a 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, state and local government bonds which are
easily saleable without affecting their market prices.
The shares and
debentures of large industrial concerns also fall in this category. But the
shares and debentures of ordinary firms are not easily marketable without
bringing down their market prices. So the banks should make investments in
government securities and shares and debentures of reputed industrial houses.
2.
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 depends upon the nature of security, the
character of the borrower, his capacity to repay and his financial standing.
Like other investments,
bank investments involve risk. But the degree of risk varies with the type of
security. Securities of the central government are safer than those of the
state governments and local bodies. And the securities of state government and
local bodies are safer than those of the industrial concerns. This is because
the resources of the central government are much higher than the state and
local governments and of the latter higher than the industrial concerns.
In fact, the share and
debentures of industrial concerns are tied to their earnings which may
fluctuate with the business activity in the country. The bank should also take
into consideration the debt repaying ability of the governments while investing
in their securities. Political stability and peace and security are the
prerequisites for this.
Like other investments,
bank investments involve risk. But the degree of risk varies with the type of
security. Securities of the central government are safer than those of the
state governments and local bodies. And the securities of state government and
local bodies are safer than those of the industrial concerns. This is because
the resources of the central government are much higher than the state and
local governments and of the latter higher than the industrial concerns.
In fact, the share and
debentures of industrial concerns are tied to their earnings which may
fluctuate with the business activity in the country. The bank should also take
into consideration the debt repaying ability of the governments while investing
in their securities. Political stability and peace and security are the
prerequisites for this.
It is very safe to
invest in the securities of a government having large tax revenue and high
borrowing capacity. The same is the case with the securities of a rich
municipality or local body and state government of a prosperous region. So in
making investments the bank should choose securities, shares and debentures of
such governments, local bodies and industrial concerns which satisfy the
principle of safety.
Thus from the bank’s
viewpoint, the nature of security is the most important consideration while
giving a loan. Even then, it has to take into consideration the
creditworthiness of the borrower which is governed by his character, capacity
to repay, and his financial standing. Above all, the safety of bank funds
depends upon the technical feasibility and economic viability of the project
for which the loan is advanced.
3.
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
security but in different types 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
governments and local bodies. Diversification aims at minimizing risk of the
investment portfolio of a bank.
The principle of
diversity also applies to the advancing of loans to varied types of firms,
industries, businesses and trades. A bank should follow the maxim: “Do not keep
all eggs in one basket.” It should spread it risks by giving loans to various
trades and industries in different parts of the country.
4.
Stability:
Another important
principle of a bank’s investment policy should be to invest in those stocks and
securities which possess a high degree of stability in their prices. 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.
Government bonds and
debentures of companies carry fixed rates of interest. Their value changes with
changes in the market rate of interest. But the bank is forced to liquidate a
portion of them to meet its requirements of cash in cash of financial crisis.
Otherwise, they run to their full term of 10 years or more and changes in the
market rate of interest do not affect them much. Thus bank investments in
debentures and bonds are more stable than in the shares of companies.
5.
Profitability:
This is the cardinal
principle for making investment by a bank. It 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 shares
depends upon the interest rate and the dividend rate and the tax benefits they
carry.
It is largely the
government securities of the center, state and local bodies that largely carry
the exemption 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 safe investments.
Conclusion:
In an attempt to comply
with the principles of lending banks develop/design certain questions when
answered will provide basic information that fulfills the guiding principles of
lending. These questions are called CANONS of LENDING.
These are:
i.
How much does the customer want to
borrow?
ii.
Why does the customer want bank
facility?
iii.
How long the loan facility would last?
iv.
How
the loan is intended to be repaid?
v.
Is the customer’s business financially
strong enough to keep going if his plans suffer a set back?
vi.
What kind of security (collateral) can
be offer?