Principles of Lending, Different Types of Borrowers, and Types of Credit Facilities | PAPER II – PRINCIPLES & PRACTICES OF BANKING | MODULE B: FUNCTIONS OF BANKS
Banking Finance: Lending Principles and Credit Facilities
1. Principles of Lending
Principles of lending are guidelines followed by financial institutions to ensure loans are safe and recoverable. They include:
- Safety: Assurance of repayment from borrower’s cash flows and assets.
- Liquidity: Loans should be recoverable when needed.
- Profitability: Loans should earn reasonable interest and fees.
- Purpose: Loan should have a legitimate and productive use.
- Diversification: Spread credit risk across sectors and borrowers.
Example: A bank evaluates a loan request from a manufacturing firm by assessing the firm's income, market, financial statements, and loan purpose before sanctioning a loan.
2. Different Types of Borrowers
Borrowers can be categorized as:
- Individuals: Retail customers borrowing for personal use (e.g., home loans).
- Proprietorships/Partnerships: Small businesses requiring working capital or term loans.
- Companies: Private or public limited companies for business expansion or operations.
- Government Entities: State or central government bodies for infrastructure or social programs.
3. Types of Credit Facilities
- Fund-Based: Facilities involving direct outflow of funds (e.g., cash credit, term loan).
- Non-Fund Based: No immediate cash outflow; contingent liabilities (e.g., Bank Guarantee, Letter of Credit).
- Other Credit Facilities: Includes overdrafts, bill discounting, export finance.
4. Fund-Based Working Capital Facilities
These support day-to-day operational needs of businesses.
- Cash Credit: Borrower draws funds against inventory or receivables.
- Overdraft: Temporary facility to overdraw account up to a limit.
Example: A firm has a cash credit limit of ₹50 lakhs, secured by stock and debtors.
Mathematical Illustration:
If Drawing Power = 75% of (Stock + Debtors - Creditors), then:
Stock = ₹30 lakhs, Debtors = ₹25 lakhs, Creditors = ₹10 lakhs
DP = 75% of (30 + 25 - 10) = 75% of 45 = ₹33.75 lakhs
5. Term / Demand Loans
Term Loan: Given for asset creation, repayable in installments.
Demand Loan: Repayable on demand, short-term in nature.
Example: A company takes a term loan of ₹1 crore for machinery, repayable over 5 years.
6. Non-Fund Based Facilities
- Letter of Credit (LC): Used in trade finance; ensures payment to suppliers.
- Bank Guarantee: Bank promises to pay if applicant defaults.
Example: A contractor provides a performance guarantee to the government worth ₹10 lakhs via a bank guarantee.
7. Other Credit Facilities
- Bill Discounting: Advance against bills receivable.
- Export Credit: Finance offered to exporters pre-shipment or post-shipment.
- Overdrafts: Allowed overdrawing facility against security or salary.
8. Multiple Choice Questions (MCQs)
- Which is NOT a principle of lending?
a) Safety
b) Liquidity
c) Profitability
d) Inflation Control ✅ - Cash Credit is a:
a) Term Loan
b) Fund-Based Facility ✅
c) Non-Fund Based
d) Investment - Which borrower type is usually eligible for retail loans?
a) Individuals ✅
b) Corporates
c) Governments
d) NGOs - Bank Guarantee is a:
a) Fund-Based Loan
b) Non-Fund Based Facility ✅
c) Working Capital
d) Credit Card - Drawing Power depends on:
a) Term Loan amount
b) Overdraft balance
c) Stock and Debtors minus Creditors ✅
d) None of these - Term Loans are generally used for:
a) Asset Creation ✅
b) Daily Expenses
c) Credit Cards
d) Insurance - Letter of Credit is used in:
a) Insurance
b) Credit Rating
c) Trade Finance ✅
d) Mutual Funds - Overdraft is a facility that allows:
a) Drawing beyond account balance ✅
b) Fixed deposits
c) Export financing
d) Term repayment - Which facility provides immediate cash against bills?
a) Guarantee
b) Bill Discounting ✅
c) Term Loan
d) Cash Credit - Export finance is categorized as:
a) Term Loan
b) Investment
c) Other Credit Facility ✅
d) Overdraft
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