Tuesday, April 12, 2016

Types of Loans and Advances by Banks and Lending Principles of Banks

Lending of money by Banks and Its principles
Lending money is one of the primary functions of the bank. Lending of funds to individuals, traders, businessmen and industrial enterprises, is one of the important activities of commercial banks. Interest earns on these loans and advances are the major source of income of the banks. Interest given on deposits is lower than the interest received on such loans and advances. Amount deposited by the customers forms the main source of loans and advances.
Various types of loans and advances given by banks: Banks lend money in various forms for various purposes which are given below:
1)      Cash Credit: Cash Credit is a type of advance wherein a banker permits his customer to borrow money upto a particular limit by a bond of credit with one or more securities. The advantage associated with this system is that a customer can withdrawn money as and when required. The bank will charge interest only on the actual amount withdrawn by the customer. Many industrial concerns and business houses borrow money in this form.
2)      Overdraft: An overdraft is an arrangement by which the customer is allowed to overdraw his account. It is granted against some collateral securities. The facility to overdraw is allowed through current account only. Interest is charged on the exact amount of overdrawn subject to the payment of minimum amount by way of interest.
3)      Loan: Loan is an advance in lump sum amount the whole of which is withdrawn and is supported to be rapid generally wholly at one time. It is made with or without security. It is given for a fixed period at in agreed rate of interest. Repayments may be made in installments or at the expiry of a certain period.

4)      Discounting Bill of Exchange: The bank also gives advances to their customers by discounting their bills. The net amount after deducting the amount of discount is credited to the account of customer. The bank may discount the bills with or without any security from the debtor in addition to the personal security of one or more person already liable on the bill.
Difference between Loan, Cash Credit and Overdraft:
Basis of Differences
Cash Credit
1. Mode
A loan may be given in cash or by credit to the account of the borrower.
Cash credit is always given through the current account.
Overdraft is granted to the current account holders.
2. Borrower
The borrower of loan may be a customer of the bank or otherwise.
The borrower of cash credit becomes customer of the bank when he open the current account.
An existing customer having current account is granted over draft facility by the bank.
3. Security
A loan may be granted against tangible securities or personal guarantee of the borrower.
Cash credit is always given against some tangible securities.
Overdraft may be clean, partly secured or fully secured.
4. Interest
Interest is charged on the entire amount of loan.
Interest is payable only on the amount actually utilised by the borrower.
Interest is payable on the amount overdrawn from the current account.
5. Rate of interest
The rate of interest charged by the bank in case of loan is lower than that of the cash credit and overdraft.
The interest rate in case of cash credit is higher than that of the loan and overdraft.
The rate of interest in case of overdraft is higher as compared to loans but lower than cash credit.
6. Maturity
A loan has a specific maturity date and is repayable after a fixed period to time.
Cash credit do not have a fixed maturity date and it is technically repayable on demand.
Overdraft is repayable on demand and do not have any maturity date.
7. Period of advance
A loan may be taken by the borrower for short, or medium or long period of time.
Cash credit may be obtained for short, medium or long period of time.
Overdraft is a short term temporary arrangement.
8. Number of withdrawals
In case of loan, funds are withdrawn once be the borrower.
In case of cash credit funds are withdrawn number of times by the borrower.
In case of overdraft, funds are withdrawn number of times.
The principles of sound lending by commercial banks are: Banks should follow some basic principles at the time of lending. This ensures efficient and long term working of the banks. Some of the basic principles of lending are as follows:
1)      Safety of principal: The first and foremost principle of lending is to ensure the safety of the funds lent. It means that the borrower is in a position to repay the loans, along with interest, according to the terms of the loan contract. The repayment of the loan depends upon the borrower’s (i) capacity to pay and (ii) willingness to pay. The banker should, therefore, take utmost care in ensuring that the enterprise or business to which a loan in to be granted is a sound one and the borrower is capable to repay it successfully.
2)      Profitability: Commercial banks are profit earning institutions. They must employ their funds profitably so as to earn sufficient income out of which to pay interest to the depositors, salaries to the staff and to meet various other establishment expenses and distribute dividends to the shareholder. The sound principle of lending does not sacrifice safety or liquidity for the sake of higher profitability.
3)      Marketability or Liquidity: Liquidity of loans is another principle of sound lending. The term liquidity of loan indicates quick realisation of loans from the borrowers. Banks are essentially dealers in short term funds and therefore, they lend money mainly for short term period. The banker should see that the borrower is able to repay the loan on demand or within a short notice.
4)      Purpose of the loan: Before granting loans, the banker should examine the purpose for which the loan is demanded. If the loan is granted for productive purpose, thereby the borrower will make much profit and he will be able to pay back the loan. In no case, loan is granted for unproductive purpose.
5)      Diversification: The element of risk in relation to loans cannot be totally eliminated, it can only be reduced. Risks of lending can be reduced by diversifying the loans. While granting loans, the banker should not grant a major part of the loan to one single particular person or particular firm or an industry. If the banker grants loans and advances to a number of firms, persons or industries, the banker will not suffer a heavy loss even if a particular firm or industry does not repay the loan.
6)      National policies: Banks have certain social responsibilities towards society also. The banks have to take into account the economic and social priorities of the country beside safety, liquidity and profitability. While formulating the lending policy, the banks are guided by the government policies in relation to disbursal of credit. Thus, national interest and policies are influence the lending decisions of banks.
In conclusion, it may be said that due consideration of all the principles are necessary, while evaluating a loan proposal.