UNIT 4

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 Lending is one of the most important functions of
banks.
 It is one of the oldest functions of a bank just
next to the function of accepting deposits.
 accepting deposits and
Actually, both
advancing loans are known as the main
functions of the bank.
 The bank creates loans on funds in such a manner
that it accepts from the public in a form of deposits.
Hence, the bank is lending, in practice, not own
money, but the public money.
 Therefore, the bank should take the necessary
precautions while lending money so as to insure the
repayment of once advanced money. 2
 4.2. MEANING OF
LOANS AND ADVANCES
Loans or Advances are:
 Any financial assets of a Bank
arising from a direct or indirect
advances (i.e. unplanned overdrafts,
participation in loan syndication, the
purchase of loans from other lender, etc)
or
 Commitments to advance funds by
the Bank to a person that are
conditioned on the obligation of the
person to repay the funds, either on a
specified date or dates or on demand
usually with interest.
 Contractual obligation of the Bank to
advance funds to or on behalf of 3 a
 …CONT’D
 Loans are
› money granted by creditor to a debtor
› to be paid in a future fixed period with an interest.
 To the debtor, loan means
› getting the purchasing power (i.e., money) now
› by a promise to pay at some time in future.
 In a sense, the words Credit, Debt and Loan
are synonymous:
 It could be granted to a customer based on its
Condition, character, capacity, capital and
collateral(5C’s).
 Credit or Loan is
› the liability of the debtor and
› the asset of the bank (creditor).
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 4.3. CLASSIFICATION OF
LOANS AND ADVANCES
1) BASED ON THE NATURE OF THE LOAN
 The main forms in which money is advanced by the
bank are: Loans, Cash Credits, Overdrafts, Purchase
and Discounting Bills and Call/Notice Loans.
A. Call/Notice Loans
 Are loans granted for a customer for a period
from an overnight to a maximum of 14 days.
 Are used for temporary purposes and
 Are granted without securities.
B. Cash Credit
 Is a loan granted to a borrower
 to borrow up to a certain limit
 against the security of tangible assets or guarantees.
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 Thus, CASH CREDIT may be regrouped as
1) A Secured Cash Credit and
2) A Clean Cash Credit.
 Under SECURED CASH CREDIT, the customer is required
› to provide tangible assets as security
› to cover the amount borrowed from the bank.
 In case of CLEAN CASH CREDIT, the customer is required
› to provide the bank with a promissory note,
› which is signed by one or more security or securities.
o The drawback of cash credit system is the existence of
large unutilized credit limits.
› The unutilized portion = (not income earning asset
for the banker)
› the borrower's requirement - the average use of credit
during each quarter
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 Overdraft is also a credit facility granted by
bank.
 A customer
 who has a current account
 is allowed to withdraw more than the
amount of credit balance in his account(showing
debit balance)
 For working capital purpose only
 Interest is calculated on the amount actually
overdrawn.
 The funds of the banker will be in the hands of the
customer.

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 Cash Credits  Overdrafts
 Running account(Cash  Limited to C/A
credit A/C)
 Granted for six
 Withdrawals and deposits
can be made frequently
months or a year with
through the Cash Credit subject to renewal up
account. on the agreement of
 Granted for long period both parties
of time  Used to solve
 Used to alleviate temporary financial
permanent financial deficit by the
problem of the customer customer.

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 Bills
 Are negotiable instruments
 Issued
 to facilitate trade and transaction.
 Bills may be DEMAND or TIME bill.
 DEMAND BILLS are payable on demand
whereas
 TIME BILLS are payable at the expiry of the
period.
 To facilitate this transaction
 the banker buys
the bill before the maturity date
with a lesser value than its face value or maturity
value,
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 The time period may be short-term,
intermediate/medium term and long-term loans.
 SHORT-TERM LOAN is usually a loan granted up to one
year,
 INTERMEDIATE LOANS are from one to five years
and
 LONG TERM LOAN is a loan granted for above five
years.
 The banker prefers loans to cash credit because of two
reasons:
1)The bank can charge interest on the entire amount of
the loan.
2)Loan account involves a smaller operating cost than
overdraft or cash credit.
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2.BASED ON THE PURPOSE
OF THE LOAN

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 …cont’d

B. Industrial Loans
 Are loans granted to industrialists
 Have long term life
 for the purpose of
 constructing or buying industrial buildings
and
 buying other fixed assets.

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 …cont’d
C. Agricultural Loans
 Are loans granted to the agriculturalists.
 Granted for the purpose of :
 Purchasing of land,
 Cultivating and developing the land,
 Buying tractors ,fertilizer, insecticide,
selected seeds, etc
 Have both short life and long life,

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 …cont’d
D.Educational Loans
 Are loans granted to finance education
expenses of a customer.
E. Medical Loans
 Are loans granted to a customer to finance
medication expenses.

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3.Based on the Period of
the Loan Granted
1)Short-term loans: they are loans usually
Loans may be granted for different time span.
granted for a period of time up to and less
than one year.
2)Intermediate loans: they are loans usually
granted for a period of time of from one up to
five years.
3)Long-term loans: they are granted for a period
of time above five years.

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4.Based on the Nature of
Security
A. Unsecured or Clean Loans/Advances
 Are LOANS and ADVANCES
 allowed by a bank to a business person
 without any security of tangible assets
 unsecured or clean
is known as
loans/Advances.
B. Secured Advances/Loans
 Are granted against some tangible securities.
 The securities against advances are also
known as "collaterals".

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 4.4. Loan/Credit Policy
and Procedure
 Banks should develop credit policy procedures in
order to ensure full repayment of the loans and
advances which are granted to their customers
and minimize risks.
› A Bank has to follow some general
principles
› while lending money.

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 Factors that influence the
bank’s loan policy

1. Capital position of the bank

2. Solvency of the bank [Current
Asset>Current liability=the bank is more
solvent]
3. Stability of deposits(Liquidity)
4. Profitability of the bank
5. Economic conditions
6. Credit needs of the area to be served
7. Risk and profitability of the types of loans
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 …Cont’d

 The most important principles of sound

lending principles are
 liquidity,
 profitability and
 safety.

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 Liquidity
 Ensure the demand of the depositors are met
easily.

Profitability
 It is essential to meet the expenses of the bank
and to earn sufficient profits.

Safety
 Safety of the funds is very essential for the
survival of the bank.
 Advancing loans against security(by
maintaining adequate margin) and other
considerations.

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 Other considerations
A. Credit Worthiness of the
borrower(Reliability ,Responsibility and
Resources of the borrower 3Rs)
B. Financial Positions of the borrower( Profit
and Loss account, Balance sheet and Cash
flow statement for the last few years)
C. Purpose of the loan( the loan must be
granted to increase the income earnings
capacity of the borrower)
D. Amount and Period of the Loan
E. Diversification( avoid keeping all eggs in
one baskets.)
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 Items included in a loan
policy
A. Customer Classification (customers
could be classified based on their):
 Corporate customers
 Business customers
 Commercial Customers

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 B. Authority and
Responsibility
 A policy should indicate the authority and
responsibility of the Bank’s personnel.

C. Credit and Risk analysis

 there shall be clear standard regarding the risk
analysis of the credit to be granted. It starts from
setting the eligibility criteria.

The analysis must address the Five C’s of the

borrower.

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 1. Capital
 It is the money invested in the business and
is an indicator of how much is at risk
should the business fail.
 Lenders will generally consider the
company's debt-to-equity ratio to
understand how much money the lender is
being asked to lend (debt) in relation to how
much the owners have invested (equity).
 A high debt-to-equity ratio also indicates
that the company already has a high level
of loans and could be a higher financial risk.

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 2. Capacity
• It refers to the customer’s ability to meet
the loan payments. 
• The lender will want to know exactly how
you intend to repay the loan.
•The lender will consider the cash
flow from the business, the timing
of repayment, and the probability of
successful repayment of the loan.
• Lenders will also consider payment
history as an indicator of future
payment potential. For example, if 25
 3. Collateral
 The bank should consider the nature of security
offered for the advance.
 A bank should accept security which is
› easily marketable and
› stable in value.
 The bank should also verify that the borrower is
› the real owner of the security offered.
 The bank must take the possession of the security.
 A bank
 should not lend up to the full value of the
security provided
 because its value may go down with the
passage of time.
 The margin should also be sufficient to cover
 the cost of realizing the asset and 26
 4. Character
 Is the obligation that a borrower feels to
repay the loan.
 There is not an accurate way to judge character,
the lender will decide subjectively whether or not
the customer is sufficiently trustworthy to
repay the loan.
 The lender will investigate the customer’s
payment history, review a credit bureau report,
and consider the customer’s educational
background and experience in business.
 The quality of the customer’s references and
the background and experience of the
customer’s employees will also be
considered.   

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 5. Condition
 It refers to the intended purpose of the
loan, for example working capital, additional
equipment, or new offices.
 The size of loan in relation to the specific use
will help the lender evaluate your loan request.
 Conditions also include the national, industry
level, and local economic situation. 
 A volatile or unstable economic situation can
negatively impact the evaluation. However,
positive expectations can increase the
likelihood of obtaining the loan.

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 Factors to be considered
while appraising Project
loans
1. Purpose(Social viability)
It must contribute the efforts to
eliminating certain social problems like
poverty,unemployment,disease,famine,
illiteracy,etc.
2. Profitability/Viability(Financial
Viability)
3. Technical viability
4. Economic Viability
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 Financial Viability
It includes
1. The Cost of the Project
the project must be viable in terms of its cost
analysis.
the return from the investment must be greater
than the investment amount.
2. Source of Finance(helps to determine how well or
bad the business was managed in terms of finance.)
3. Source of Repayments  is the income from the
project sufficient to cover the regular repayment? Or
is there any other source of repayment incase an
adverse effect occurs to the project.
4. Terms of Repayment : Determine the schedule for
loan repayment. ( monthly, quarterly, Semi –annually
or annually)
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 Ratio Analysis
1. Debt to Equity Ratio = Total Debt
Net Worth
2. Profitability Ratio = Profit
Sales
3. Return on Capital Ratio= Profit
Capita
4. Liquidity Ratio
 Current Ratio = All Current Assets
Current Liabilities
 Quick Ratio = Cash+ cash equivalents
+receivables
Current Liabilities
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 D. Loan Follow up and
Portfolio Management
 The advances of the banks must be spread over
different regions, industries and sectors.
 The bank should not grant loan only to a few persons
or concerns.
 advance portfolio of the bank is diversified, the bank
If the
will not suffer heavy loss if a firm fails to repay the loan.
 In other words, the bank should avoid keeping all eggs in one basket.

E. NPL Management
 Bankers should put standard as to their technique
for NPL management.

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 4.5. Loan FOLLOW-UP AND
SUPERVISION
 Bankers appraise the loan applications
carefully with the idea of eliminating such
borrowers
 who may fail to keep their promises by not
repaying the loans or
 diverting money to inappropriate uses.
 But an appraisal alone can never guarantee
protection against such a type of future risk.

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 …cont’d
 In fact, supervision or follow-up
starts from the point where appraisal ends,
that is from the stage of disbursing the loan.
 At the time of disbursal, the banks should
carefully supervise the end – use of money.
 Often the money is diverted for
› purposes other than stated in the loan application,
› thus defeating the basic objectives of providing finance.

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