A Project Report on

Principles of Good Lending

Subject:
Banking Law
Submitted to:
Dr. Y. Papa Rao

Submitted by:
Apoorva Singh
(B.A.LL.B. (Hons.) IX semester, Roll no. 20)

Date of submission:
October 10th , 2014

HIDAYATULLAH NATIONAL LAW UNIVERSITY,

RAIPUR (C.G).

TABLE

OF

CONTENTS

ACKNOWLEDGEMENTS

RESEARCH METHODOLOGY

4
5

INTRODUCTION

PRINCIPLES OF LENDING

CREDIT INVESTIGATION

10

THE SIX CS

11

CONCLUSION

12

REFERENCES

13

Acknowledgements

At the outset, I would like to express my heartfelt gratitude and thank my teacher, Dr.Y. Papa
Rao for putting his trust in me and giving me a project topic such as this and for having the faith
in me to deliver. Thank you for an opportunity to help me grow.
My gratitude also goes out to the staff and administration of HNLU for the infrastructure in the
form of our library and IT Lab that was a source of great help for the completion of this project
Apoorva Singh

Research Methodology

This research is descriptive and analytical in nature. Secondary and Electronic resources have
been largely used to gather information and data about the topic.
Books and other reference as guided by Faculty of Banking Law have been primarily helpful in
giving this project a firm structure. Websites, dictionaries and articles have also been referred

Introduction
Disposing of money or property with the expectation that the same thing (or an equivalent) will
be returned. Credit is the provision of resources (such as granting a loan) by one party to another
party where that second party does not reimburse the first party immediately, thereby generating

a debt, and instead arranges either to repay or return those resources (or material(s) of equal
value.
Lending involves elements of risks. The element of risk, in the main operations of a bank, leads
to the necessity of credit investigation. It presupposes right selection of borrower, which needs
complete and comprehensive investigation of all the facts. As a matter of fact, much of the
worries of the lending banker is over if correct type borrowers can be selected. To arrive at a
decision about selection of a borrower the banker needs to collect a long chain of information
about the borrower. Usual loan application forms when filled in by the applicant provide the
banker with almost all the required particulars pertaining to the advance. The bankers
responsibility is to verify and correlate those statements and to prepare a credit report, which is
expected to give a complete, clear, correct and reliable record of the character, means and
business integrity of the borrower. On the basis of credit information and credit report, the
banker may arrive at a reasonably correct decision about the proposed advance. Credit
investigation is, therefore, a sacred and obligatory job of a lending banker for administering his
lending operations with success.

It is a fundamental precept of banking everywhere that advances are made to customers in

reliance on his promise to repay, rather than the security held by the banker. Although all lending
involves some degree of risks, it is necessary for any bank to develop sound and safe lending
policies and new lending techniques in order to keep the risk to a minimum. As such, the banks
are required to follow certain principles of sound lending.

Principles of Lending
Safety
Banks are trustee of public money. Banks deposits are always payable on demand. Bank has to
maintain trust of depositor forever. As such the first and foremost principle of lending is to
ensure safety of funds lent.
By safety means that the borrower is in a position to repay the loan, along with interest. Further,
it is just not the capacity of the borrower to repay but also his willingness to repay.
Advances should be expected to come back in the normal course. The repayment of the loan
depends upon the borrowers capacity to pay and willingness to pay. The capacity depends upon
the tangible assets of the borrower. The willingness to pay depends upon the honesty and
character of the borrower.
The banker should lend to a reliable customer who can and will repay the loan within the
prescribed period of time after generating surplus from business such that doubtful debts are
avoided. In practice, banks ensure that they adhere to this principle by taking collateral security
that is marketable, apart from primary security, which the bank can dispose off in the event of
default.
In more recent times, bankers have begun to concentrate more on the business aspect of the
borrower, i.e., the purpose and viability of the business rather than on the collaterals.
Thus, bankers have begun to treat the entire business as security and in this manner moved away
from the traditional concept of collaterals. Thus bankers must take utmost care in ensuring that
the business for which a loan is sought is a sound one, and that the borrower is a person of
integrity who is capable of carrying out his business successfully.
Liquidity
The term liquidity refers to the extent of availability of funds with the banker for providing credit
to borrowers. It is to be seen that money lent is not going to be locked up for a long time.

Liquidity is the availability of bank funds on short notice. The borrower must be in a position to
repay within a reasonable time. Liquidity also signifies that the assets should be salable without
any loss.
The money should return to the bank as per the repayment schedule. This schedule that is drawn
up by the banker has to adhere to the requirement that at any point of time the banker should
possess liquidity to meet the withdrawals of the depositors.
It is to be kept in mind that various deposits have various maturities and some of it would also be
payable on demand. A banks inability to meet the demand of its depositors can lead to a run on
the bank which is a threat to its basic survival.
Hence the banker has to always monitor the cash flows and carry out the exercise of ensuring
liquidity with the borrower as this in turn means liquidity with the banker. Further, liquidity
would also refer to the quality of assets, which should be easily convertible into cash without any
loss of value.
Thus the concept of liquidity entails the banker to look for easy sale ability and absence of risk of
loss on sale of asset, which has been taken as collateral.
Profitability
Bank are not charitable institutions. All banks are profit-earning institutions. A banker has to see
that major portion of the assets owned by it are not only liquid but also aim at earning a good
profit. Banks receive interest on loans and advances lent, and they pay interest to their
depositors. The difference between the interest received on advances and the interest paid on
deposits constitutes a major portion of banks income. Besides, foreign exchange business is also
highly remunerative.
Banks further incur various expenses as any organisation does. After accounting for all such
expenses and provisions, banks have to earn a reasonable amount as net profit (NIM) so that
dividends can be paid to its shareholders.
The trust and confidence level of the customer and investor will be high with a bank that has a
good track record of profits and dividend rates.
Hence it is important that whatever the business the bank engages itself with, the business be
profitable enough not just to cover its costs but to ensure generation of surplus funds or margin.
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It is prudent for the banker to consider overall profitability of the entire business that is
undertaken rather than the profitability against each component of business or service offered.
It is also a recent practice to analyse the profitability of operations vis--vis particular customers.
This approach, known as the Customer Profitability Analysis (CPA), enables the banker to decide
the extent to which he can compromise on the profitability aspect so that a competitive rate can
be offered to customer.

This analysis is done when more than one service is offered by the bank and to attract more
customers. In the current context of the availability of freedom to a banker in the matter of
pricing credit and services, a very conscious and careful exercise is called for on his part in order
to strike a proper balance between the twin aims of making a desirable level of profit and at the
same time offering a competitive price for the product/service.
This is the kind of approach that is required of a banker in order to entice new customers to his
fold while retaining the existing customers. There is a direct relationship between profit and
pricing of service offered by the banker.

Purpose

While lending the funds, the banker enquires from the borrower the purpose for which he seeks
the loan. Banks do not grant loans for each and every purpose. A banker would not throw away
money for any purpose for which the borrower wants. The purpose should be productive so that
the money not only remains safe but also provides a definite source repayment.
The funds lent should be put to optimum use. Loans are not to be granted for speculative and
unproductive purposes like hoarding stock or for anti-social activities, since apart from the

morality of such activities, there are also inherent risks involved with regard to the repayment of
such loans.
Loans that are meant for personal expenditure like marriage cane be refused. In some cases, the
banks grant loans for personal expenditure and for short/medium term like for education etc.
It is however the duty of the bank to keep in mind that the other principles of lending are adhered
to, which in turn will automatically ensure that this principle is taken care of as well.

Security

The security offered against the loans may consist of a large variety of items. It may be a plot of
land, building, flat, gold ornaments, insurance policies, term deposits etc. There may even be
cases where there is no security at all. Security serves as a safety valve for an unexpected
emergency. The security offered for an advance is a cushion to fall back upon in case of need. An
element of risk is always present in every advance however secured it might appear to be.
Nevertheless, the security if accepted must be adequate and readily marketable, easy to handle
and free from encumbrances. It is the duty of the banker to check the nature of the security and
assess whether it is adequate for the loan granted. Apart from the collateral, the banker has also
to consider other factors such as capital of the borrower, his character and capacity.
Risk management through diversification
A prudent banker always tries to select the borrower very carefully and takes tangible assets as
security to safeguard his interests. While this is no doubt an adequate measure, there are other
unforeseen contingencies against which the banker has to guard himself. Further if the bank
lends large amounts to a single industry or borrower, then the default by that customer can affect
the banking industry as a whole and will affect the basic survival of the industry.

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The advances should be as much broad-based as possible and must be in keeping with the
deposit structure. The advances must not be in one particular direction or to one particular
industry. Again, advances must not be granted in one area alone.
To safeguard his interest against all such risks, the banker follows the principle of diversification
of risks based on the famous maxim never keep all the eggs in one basket. By lending funds to
different sectors, a bank can save itself from the slump in some sectors by way of prosperity in
the others. Banks have to lend to a large number of industries and borrowers so that the risk gets
diversified.

Credit Investigation
It is of utmost importance that the banker assesses his borrower well. As mentioned above, the
borrower should not only have the capacity to repay as per banks requirements but should also
have the willingness to repay. There are certain important checkpoints that the banker has to go
through to ensure this.
Different phases of Credit Investigation:
1) Collection of information of the entrepreneur
2) Preparation and analysis of this information in order to determine creditworthiness of the
borrower/ entrepreneur
3) Making decisions and recommendations about the borrower
4) Furnishing credit information to other bankers
5) Retention of the information for future use
On the basis of credit investigation, bankers prepare a credit report for the applicant usually as
per Performa used by the respective bank.
In selecting the borrower, the following aspects should be considered:
1) Past behavior of the borrower requires to be studied. Enquiry should be made whether the
applicant has availed of any loan previously from other bank and whether his dealings
with that bank are regular or not.
2) Work experiences of the intending borrowerwhat are the activities undertaken by him
his successes and failures along with analysis of the underlying factors.

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3) Whether the work area has any relevance to the project proposed to be undertaken by
him.

The Six Cs
On investigation and inquiry the banker reaches his conclusion to select a borrower that qualifies
the 6 essentials, which may be termed as six Cs:
Character
Character denotes integrity of the borrower i.e. he should have willingness to repay the money
borrowed. The banker should investigate every aspect of the character factor and should
convince himself that despite adverse conditions, the applicant will make every effort to
discharge his debt as per terms.
He should assess the personal characteristics which include honesty, attitude, willingness and
commitment to repay debts. There is however no set guidelines to carry out such an assessment.
The characteristics are very personal in nature and in fact it may not be possible to carry out a
fool-proof analysis. The banker should nevertheless carry out this assessment with sincerity.
Capacity
Capacity means the ability to employ the funds profitably according to the terms and conditions.
The capacity of the borrower has to be determined to find out his experiences in the line in which
he is working.
This includes the evaluation whether the borrower has the potential to repay the loan from his
own resources. It includes the borrowers success in running in business or managing his cash
flows. Capacity of physical assets, plants and equipment, cash flows etc are usually taken into
account in this regard. Banks normally insist upon their prospective borrowers to submit their

12

financial statements in order to determine their creditworthiness. The importance of financial

statements in this regard will be dealt with in the forthcoming units.
Capital
Capital denotes financial soundness. The borrower must have his own stake in the business
which creates a sense of involvement in the mind of the borrower. Capital is the financial
strength of a risk as measured by the equity or net worth of the business. The financial strength
of the borrower or his net worth is carefully studied by the banker. It represents the amount of
equity capital that a firm can liquidate for payment of debt n the eventuality of call other means
failing. The amount of the borrowers capital in relation to debt is relatively easy to compute.
However, the valuation of underlying assets in which capital is invested is a complex but vital
exercise and has to be carried out.
Condition
Condition refers to the general business condition and the conditions in the particular industry in
which the borrower is engaged. The banker should exercise prudence whether the business
establishments are existent and continuing their business.
The banker has to assess the conditions in which the borrower is operating his business. A STEP
analysis may come in handy in this regard. STEP stands for Social, Technological, Economic and
Political conditions. The market potential of the product, the competitiveness of the firm in the
market, the growth prospects and other such factors influence the borrowers ability to repay the
debt. The banker must also consider external factors that maybe beyond the control of the firm
but may nevertheless affect the business.
Collateral
Collateral implies the additional securities taken to offset weaknesses that are apparent. All of the
collateral that may be made available to the bank will not make a bad loan good but it will make
good loan better. While assessing valuation of collateral securities bankers need to take extra care
by sampling survey and by examining information from land revenue office and also enquiring
people nearby. The documents of the collateral securities are to be verified from the concerned
Sub-Registered Office and other related office.
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Compliance
The loan, which is to be given to the borrower, should be in accordance with the rules and
regulations as stipulated. Banker has to ensure that all the formalities are met as its absence may
cause a concern for recovery of the loan. Hence to safeguard this interest banker has to conform
to the guidelines issued by the government and regulatory authorities.

Conclusion
An ideal advance is one which is granted to a reliable customer for an approved purpose in
which the customer has adequate experience, safe in the knowledge that the money will be used
to advantage and repayment will be made within a reasonable period from trading receipts or
known maturities due on or about given dates.
And to arrive at a decision about selection of a borrower the banker needs to conduct credit
investigation and On the basis of credit information and credit report, the banker may arrive at a
reasonably correct decision about the proposed advance.
While conducting the investigation and selecting the customer, banker needs to follow certain
principles which are necessary and these principles have been discussed above and a banker must
keep all these principles in mind while lending.

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References

file:///C:/Users/intel/Documents/banking/amazing.htm
file:///C:/Users/intel/Documents/banking/Basic%20Principles%20of%20Sound

%20Lending.htm
http://kalyan-city.blogspot.com/2010/09/principles-of-good-lending-every-banker.html
file:///C:/Users/intel/Documents/banking/Principles%20of%20bank%20lending%20&

%20Priority%20sector%20lending.htm
file:///C:/Users/intel/Documents/banking/Knowledge%20Bank%20-%20General
%20Principles%20of%20Lending.htm

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