Lending by Banks
The concept of bank lending has been undergoing a change since the introduction of social control over commercial banks and more especially after the nationalisation of major banks in 1969. Prior to nationalisation, the commercial banks provided credit only to large customers with larger resources at their command against the securities which were more than adequate to cover the advances. In other words, a large part of the banks lending was security oriented and that to a selected customers in the corporate sector. However, since nationalisation there has been a view that the bankers should not insist on security in consideration of the proposals for advances. They should look at the productivity of a proposal in terms of its potentialities to contribute to increased production.
Lending of funds to the constituents, mainly business and industrial enterprises, traders, constitutes the main business of the banking company. The major portion of the bank's fund is employed by way of loans and advances, which is the most profitable employment of its funds.
The business of lending, nevertheless, is not without certain inherent risks. Largely depending on the borrowed funds a banker cannot afford to take undue risks in lending.
When banker lending his finds, follows a very cautious policy and conducts his business on the basis of the well known principles of sound lending in order to minimise the risks.
Safety: 'Safety first' should be the first guiding principle of a banker. A banker must look to the safety of the funds as he cannot afford to lose the money he lends. He should take a long term view rather than the immediate prospects. Banks always provided fully secured loans and advances in the ordinary course of his business. This has led people to believe that bank will never advance any loan unless it is fully secured. Such is no doubt the ideal conception of banking, but as a result of competition from other banks, every bank has sometimes to grant loans to its customer against their personal security. In many cases, the manager of the bank uses his discretion and never lends a sum obviously beyond his customer's resources.
Liquidity: Secondly, the banker while making advances must see that the money he is lending is not going to be locked up for a long time, which should make his loans and advances less liquid and more difficult to release in case of emergency. Banks always depend on borrowed funds; they spread their investment in such a way that they are in a position to acquire cash with in short period of time. Their borrowings also come from deposits which are usually not for a very long period.
Profitability: Commercial banks are profit earning institutions. The nationalized banks are no exception to this. 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 dividend to the shareholders. The rates of interest charged by banks were in the past primarily dependent on the directives issued by Reserve Bank. Now banks are free to determine their own rates of interest on advances of above Rs. 2 Lakhs. The variations in the degree of risk are involved in lending to them. A customer with high reputation is charged the lower rate of interest as compared to an ordinary customers. The sound principle of lending is not to sacrifice safety or liquidity for the sake of higher profitability. That is to say that the banks should not grant advances to unsound parties with doubtful repaying capacity, even if they are ready to pay a very high rate of interest.
Security: The security offered against the loan may consist of a large variety. It may vary from a piece of land or a building to a commercial paper or bullion. There may be cases where there is no security except the personal security of the debtors. Whatever be the security, a banker must realize that it is only a cushion to fall back upon in case of need and its adequacy alone should not from the sole consideration for judging the suitability of a loan. Of course, the security, if accepted, must be adequate, readily marketable, easy to handle and free from encumbrance.
Loans Repayable on Demand: Bankers generally make their loans repayable on demands, although there may be an understanding that the customer would be allowed to use the funds for at least a certain period, provided he complies with the term of the agreement. They also reserve to themselves the power of cancelling or reducing the amount of advances, but generally they have to give a reasonable notice. For expo: A banker who has promised his customer an overdraft to the extent of Rs.20,000/-, wishes to reduce its amount to Rs. 15,000/-. He cannot refuse to honour his customer's cheque issued before the receipt of the notice by the customer, so long as it does not exceed the limit of the overdraft originally agreed upon Rouse Vs. Bradford Banking company (1894) AC 595. Investment of Their Fund in Various Sectors : It is also necessary to remember that a prudent banker must avoid lending the major portion of his funds in meeting the needs of any one industry on anyone group of Industries for consideration of self - Interest as well as the large public good. The imprudence of putting one's all eggs in one basked can not be too often reiterated.
Adequate Return on his Investment: Another important factor that will determine the decision of the banker whether or not to grant a loan will depend upon the answer to the question whether or not he will get a fair return on his investment. The difference between his borrowing and lending rates constitutes his gross profit and no banker ordinarily will think of an advance without a satisfactory margin of profit. No hard and fast rules can however, be laid down regarding this margin between borrowing and lending rates, but generally 2 to 2112 % is considered reasonable.