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

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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)

1. Which is NOT a principle of lending?
   a) Safety
   b) Liquidity
   c) Profitability
   d) Inflation Control ✅
2. Cash Credit is a:
   a) Term Loan
   b) Fund-Based Facility ✅
   c) Non-Fund Based
   d) Investment
3. Which borrower type is usually eligible for retail loans?
   a) Individuals ✅
   b) Corporates
   c) Governments
   d) NGOs
4. Bank Guarantee is a:
   a) Fund-Based Loan
   b) Non-Fund Based Facility ✅
   c) Working Capital
   d) Credit Card
5. Drawing Power depends on:
   a) Term Loan amount
   b) Overdraft balance
   c) Stock and Debtors minus Creditors ✅
   d) None of these
6. Term Loans are generally used for:
   a) Asset Creation ✅
   b) Daily Expenses
   c) Credit Cards
   d) Insurance
7. Letter of Credit is used in:
   a) Insurance
   b) Credit Rating
   c) Trade Finance ✅
   d) Mutual Funds
8. Overdraft is a facility that allows:
   a) Drawing beyond account balance ✅
   b) Fixed deposits
   c) Export financing
   d) Term repayment
9. Which facility provides immediate cash against bills?
   a) Guarantee
   b) Bill Discounting ✅
   c) Term Loan
   d) Cash Credit
10. Export finance is categorized as:
    a) Term Loan
    b) Investment
    c) Other Credit Facility ✅
    d) Overdraft