Principles of

lending
Submitted bykomal(47)
Naresh(40)

Principle of lending
The business of lending, which is main
business of the banks, carry certain
inherent risks and bank cannot take more
than calculated risk
whenever it wants to lend. Hence, lending
activity has to necessarily adhere to
certain principles.
Lending principles can be conveniently
divided into two areas (i) activity, and (ii)
individual.

lending
Activity
individual
safety
profitability
stability
diversity
liquidity
Security
5
Process
Cs ofof
the
Appraisal
Lending
borrower

liquidity
Liquidity is an important principle of bank lending.
Bank lend for short period only because they lend
public money which can be withdrawn at any time by
depositors.
They therefore advances loans on security of such
assets which are easily marketable and convertible
into the cash at 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 requirement of its customers, it should be in
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, states and
local govt. bonds which are easily saleable without
affecting the price of market

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 depend upon the
nature of the security, character of the borrower,
his capacity to repay and his financial standing.
Like other investment bank investments involves
risk but the degree of risk varies with the type of
the securities of the central govt. are safer than
those of the state govt. and local bodies.

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 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 govt. and local bodies.
Its aim at minimizing risk of the investment
portfolio of a bank. it also applies to the
advancing of loans to varied types of firms,
industry, business and trades.
Do not keep all eggs in one basket

stability
Another important principle of banks investment policy
should be to invest in those stocks and securities which
possess a high degree of stability in their price.
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. Govt. bonds and debentures of
companies carry fixed rates of interest.
Their value change with change in the market rate of
interest. But the bank is forced to liquidate a portion of
them to meet its requirement of cash in cash of financial
crisis.
Otherwise they run to their full term of 10 years or more
and change in the market rate of interest do not affect
them much. Thus banks investments in debentures and
bonds are more stable than in the shares of the companies.

profitability
This is the cardinal principle for making investment
by a bank. Its 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 share
depends upon the interest rate and the dividend
rate and the tax benefits they carry.
It is largely the govt. securities of the centre, state
and local bodies that largely carry the exemptions 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 the safe investment.

Secured Advances
Cardinal principle of sound banking is to ensure
safety of funds lent by banker to his customers.
The banker therefore relies on primarily on the
3 Cs of borrower.
Secured advances are those advances which
provide absolute safety to the banker in means
of charge created on the tangible assets of
the borrower in favor of the banker.

Modes of creating charge :

Lien

Section 171 of the Indian Contract Act

confers the right of general lien on the
banker.
The banker is empowered to secure all
securities of the customers, in result of
the general balance due from him.
The ownership of stock securing is not
transferred from the customer to the
banker.

Negative Lien

The borrower gives a declaration to the

banker that his assets mentioned therein
are free from any charge or encumbrance.
He also gives an undertaking that he shall
not create any charge or dispose them off
without permission of the banker.
The borrower cannot dispose of the assets
or create any charge there on without the
consent of the banker.

PLEDGE
Sec. 172 of the Indian Contract Act 1872 defines
pledge as bailment of goods as security for payment of
debt or performance of a promise.
Pledge is used when the lender (pledgee) takes actual
possession of assets (i.e. certificates, goods ). Such
securities or goods are movable securities. In this case the
pledgee retains the possession of the goods until the
pledgor (i.e. borrower) repays the entire debt amount. In
case there is default by the borrower, the pledgee has a
right to sell the goods in his possession and adjust its
proceeds towards the amount due (i.e. principal and interest
amount). Some examples of pledge are Gold /Jewellery
Loans, Advance against goods,/stock, Advances against
National Saving Certificates etc.

The person who offer security is called PLEDGER

To whom it is offered is called PLEDGEE

HYPOTHECATION :
It is used for creating charge against the security of movable
assets, but here the possession of the security remains with the
borrower itself.
Thus, in case of default by the borrower, the lender (i.e. to whom
the goods / security has been hypothecated) will have to first take
possession of the security and then sell the same.
The best example of this type of arrangement are Car Loans.In
this case Car / Vehicle remains with the borrower but the same is
hypothecated to the bank / financer.
In case the borrower, defaults, banks take possession of the
vehicle after giving notice and then sell the same and credit the
proceeds to the loan account.
Other examples of these hypothecation are loans against stock
and debtors. [Sometimes, borrowers cheat the banker by partly
selling goods hypothecated to bank and not keeping the desired
amount of stock of goods.
In such cases, if bank feels that borrower is trying to cheat, then it
can convert hypothecation to pledge i.e. it takes over possession
of the goods and keeps the same under lock and key of the bank].

MORTGAGE :
Sec. 58 of the transfer of property Act 1882 defines
mortgage as
It is used for creating charge against immovable property which
includes land, buildings or anything that is attached to the earth or
permanently fastened to anything attached to the earth (However,
it does not include growing crops or grass as they can be easily
detached from the earth).
The best example when mortage is created is when someone takes
a Housing Loan / Home Loan.In this case house is mortgaged in
favour of the bank / financer but remains in possession of the
borrower, which he uses for himself or even may give on rent.
In this case transfer is called MORTGAGOR
Transferee is called MORTGAGEE
Principle money & Int. thereon is called MORTGAGE MONEY
Instrument is called MORTGAGE DEED.

Forms of mortgage

Simple Mortgage
Mortgage by condition sale
English Mortgage
Mortgage by deposit of title deed
equitable mortgage
Anomalous mortgage

or

Difference Between Pledge,

Hypothecation and Mortgage

Pledge

Hypothecation

Mortgage

TypeofSecurity

Movable

Movable

Immovable

Possessionofthe
security

Remains with lender Remains with

(pledgee)
Borrower

ExamplesofLoan
whereused

Gold Loan, Advance

against NSCs, Adv
Car / Vehilce Loans,
against goods (also Adv against stock and Housing Loans
given under
debtors
hypothecation)

Usually Remains with

Borrower

Difference between Charge, Hypothecation and Mortgage

Nature of
Security

Posession

Nature of
Interest
in the
Property

Necessity
for
obtaining
Court
approval
for
enforceme
nt of
security

Step-in
Rights

Transferring the
Interest

Charge/
Hypothecati
on

No
possession

Special
Property

Approach
Court
except if
the
agreement
specifically
provides for
private sale

No

Cannot be assigned

Pledge

Possession

Special
Property

No need to
approach
court

No

Can be assigned

Mortgage

Possession
or No
possession
(depending

General
Property

No need to
approach
court
(except

Yes

Can be assigned

17

Difference
Pledge-a serious or formal promise, especially one to
give money or to be a friend, or something that you
give as a sign that you will keep a promise
mortgage-an agreement which allows you to borrow
money from a bank or similar organization, especially
in order to buy a house or apartment, or the amount
of money itself
HypothecationHypothecation is the practice where a
borrower pledges collateral to secure a debt
lien-an official order that allows someone to keep the
property of a person who owes them money until it
has been paid

 Mortgage A mortgage is a lien on a property/house

that secures a loan and is paid in installments over
a set period of time. The mortgage secures your
promise that you'll repay the money you've
borrowed to buy your home/property.
Pledge Something given or held as security to
guarantee payment of a debt or fulfillment of an
obligation.
Hypothecation It is a charge in or upon any movable
property, existing or future, created by a borrower in
favour of a secured creditor without delivery of
possession of the movable property to such creditor
as a security for financial assistance.

Priority Sector
Priority sector refers to those sectors of
the economy which may not get timely
and adequate credit in the absence of this
special dispensation.
Typically, these are small value loans to
farmers for agriculture and allied
activities, micro and small enterprises,
poor people for housing, students for
education and other low income groups
and weaker sections.

Categories under priority sector

(i) Agriculture
(ii) Micro and Small Enterprises
(iii) Education
(iv) Housing
(v) Export Credit
(vi) Others

Targets and Sub-targets for banks

under priority sector
Categories

Domesticcommercialbanks/
Foreignbankswithless
Foreignbankswith20andabove
than20branches(As
branches(AspercentofANBCor percentofANBCorCredit
CreditEquivalentofOff-Balance EquivalentofOff-Balance
SheetExposure,whicheveris SheetExposure,whichever
higher)
ishigher)

Total Priority Sector

40

32

Total agriculture

18

No specific target.

Advances to Weaker
Sections

10

No specific target.

'Direct Finance' for Agricultural

Purposes
Loans to individual farmers [including Self Help Groups (SHGs) or
Joint Liability Groups (JLGs), i.e. groups of individual farmers]
engaged in Agriculture and Allied Activities, viz., dairy, fishery,
animal husbandry, poultry, bee-keeping and sericulture.
(ii) Loans to corporate including farmers' producer companies of
individual farmers, partnership firms and co-operatives of farmers
directly engaged in Agriculture and Allied Activities, viz., dairy,
fishery, animal husbandry, poultry, bee-keeping and sericultureup to
an aggregate limit of `2 crore per borrower.
(iii) Loans to small and marginal farmers for purchase of land for
agricultural purposes.
(iv) Loans to distressed farmers indebted to non-institutional lenders.
(v) Bank loans to Primary Agricultural Credit Societies (PACS),
Farmers Service Societies (FSS) and Large-sized Adivasi Multi
Purpose Societies (LAMPS) ceded to or managed/ controlled by such
banks for on lending to farmers for agricultural and allied activities.
(i)

'Indirect Finance' to Agriculture

(i) If the aggregate loan limit per borrower is more

than `2 crore in respect of para. (4) (ii) above, the
entire loan will be treated as indirect finance to
agriculture.
(ii) Loans upto `5 crore to Producer Companies set up
exclusively by only small and marginal farmers
under Part IXA of Companies Act, 1956 for
agricultural and allied activities.
(iii) Bank loans to Primary Agricultural Credit
Societies (PACS), Farmers Service Societies (FSS)
and Large-sized Adivasi Multi Purpose Societies
(LAMPS).

Micro and Small Enterprises under priority

sector

Bank loans to Micro and Small

Manufacturing and Service
Enterprises, provided these units
satisfy the criteria for investment in
plant machinery/equipment as per
MSMED Act 2006.

Manufacturingsector
Enterprises

Investment in plant and machinery

Micro Enterprises

Do not exceed twenty five lakh rupees

Small Enterprises

More than twenty fivelakh rupees but does not

exceed five crore rupees

Enterprises

Investment in equipment

Micro Enterprises

Does not exceed ten lakh rupees

Small Enterprises

More than ten lakh rupees but does not exceed two
crore rupees

Loan limit for education under

priority sector
Loans to individuals for educational
purposes including vocational
courses upto `10 lakh for studies in
India and `20 lakh for studies abroad
are included under priority sector.

limit for housing loans under priority sector

Loans to individuals up to `25 lakh in

metropolitan centres with population
above ten lakh and `15 lakh in other
centres for purchase/construction of
a dwelling unit per family excluding
loans sanctioned to banks own
employees.

under Weaker Sections under priority sector

Priority sector loans to the following borrowers are considered under
Weaker Sections category:(a) Small and marginal farmers;
(b) Artisans, village and cottage industries where individual credit limits do
not exceed `50,000;
(c) Beneficiaries of Swarnjayanti Gram Swarozgar Yojana (SGSY), now
National Rural Livelihood Mission (NRLM);
(d) Scheduled Castes and Scheduled Tribes;
(e) Beneficiaries of Differential Rate of Interest (DRI) scheme;
(f) Beneficiaries under Swarna Jayanti Shahari Rozgar Yojana (SJSRY);
(g) Beneficiaries under the Scheme for Rehabilitation of Manual Scavengers
(SRMS);
(h) Loans to Self Help Groups;
(i) Loans to distressed farmers indebted to non-institutional lenders;
(j) Loans to distressed persons other than farmers not exceeding `50,000
per borrower to prepay their debt to non-institutional lenders;
(k) Loans to individual women beneficiaries upto `50,000 per borrower;

The rate of interest for loans under

priority sector
The rate of interest on various
priority sector loans will be as per
RBIs directives issued from time to
time, which is linked to Base Rate of
banks at present. Priority sector
guidelines do not lay down any
preferential rate of interest for
priority sector loans