Banking "Principles Of Sound Lending & Types Of Banking" Chapter-2

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Principles of Sound Lending

Lending is one the primary function of a bank. The banks accept deposits from people and then lend that money to the needy people in the form of loans, advances, cash credit and overdraft. Interest received from these lending is the main source of income for the bank. So a bank should examine the security offered against loan, credit worthiness of the borrower and the purpose of the loan. Therefore a bank uses these following principle for smooth running of the business.
  1. Liquidity - Liquidity is an important principle of bank lending. Banks lend money for short periods only because they lend public money (money accept as deposits from people) which can be withdrawn at any time by depositors. They, therefore, advance loans on the security of such assets which can be easily converted into cash at a short notice. A bank chooses such securities because if the bank needs cash to meet the urgent requirements of its customers, it should be in a position to sell some of the securities at a very short notice without disturbing their price much. There are certain securities such as central, state and local government bonds which are easily saleable without affecting their market prices.
  2. Safety - The safety of funds lent is another principle of lending. Safety means that the borrower should be able to repay the loan and interest in time at regular intervals without default. The repayment of the loan depends upon the nature of security, the character of the borrower, his capacity to repay and his financial standing. Like other investments, bank investments involve risk. But the degree of risk varies with the type of security. Securities of the central government are safer than those of the state governments and local bodies. From the point of view, the nature of security is the most important consideration while giving a loan. Even then, it has to take into consideration the creditworthiness of the borrower which is governed by his character, capacity to repay, and his financial standing. Above all, the safety of bank funds depends upon the technical feasibility and economic viability of the project for which the loan is advanced.
  3. Diversity - A commercial bank should follow the principle of diversity. It should not invest its surplus funds in a particular type of security but in different types of securities. It should choose the shares and debentures of different types of industries situated in different regions of the country. The same principle should be followed in the case of state governments and local bodies. Diversification aims at minimizing risks of the investment portfolio of a bank. The principle of diversity also applies to the advancing of loans to varied types of firms, industries, businesses and trades. A bank should follow the maxim: “Do not keep all eggs in one basket.” It should spread it risks by giving loans to various trades and industries in different parts of the country.
  4. Stability in the Value of Investments - The bank should invest its funds in those stocks and securities the prices of which are more or less stable. The bank cannot afford to invest its funds in securities, the prices of which are subject to frequent fluctuations.
  5. Profitability - A commercial bank by definition is a profit hunting institution. The bank has to earn profit to pay salaries to the staff, interest to the depositors, dividend to the shareholders and to meet the day-to-day expenditure. Since cash is the least profitable asset to the bank, there is no point in keeping all the assets in the form of cash on hand. The bank has got to earn income. Hence, some of the items on the assets side are profit yielding assets. They include money at call and short notice, bills discounted, investments, loans and advances, etc. Loans and advances, though the least liquid asset, constitute the most profitable asset to the bank. Much of the income of the bank accrues by way of interest charged on loans and advances. But, the bank has to be highly discreet while advancing loans.
  6. Saleability of Securities - Further, the bank should invest its funds in such types of securities as can be easily marketed at a time of emergency. The bank cannot afford to invest its funds in very long term securities or those securities which are unsaleable. It is necessary for the bank to invest its funds in government or in first class securities or in debentures of reputed firms. It should also advance loans against stocks which can be easily sold.
  7. Margin Money – in case of secured loans (A secured advance is one which is made on the security of either assets or against personal security or other guarantees. An advance which is not secured is called an unsecured advance), the bank should carefully examine and value of security. There should be sufficient margin between the amount of loan and value of the security. If adequate margin is not maintained, the loan might become unsecured, in case the borrower fails to pay the interest and return the loan. Margin means a sufficient gap between loan value and security value for ex if security market value is Rs 1000 then bank may offer Rs 800 as loan.
  8. Principle of Purpose - At the time of granting an advance the banker must ask about the purpose of the loan. If it is for unproductive purposes, then there is less chances of repayment of loan. On the other hand, If it is for productive purposes then there is more chances of repayment loan value with the interest.
Secured Advances

A secured advance is one which is made on the security of either assets or against personal security or other guarantees. An advance which is not secured is called an unsecured advance.

Objective of Securities :-

The basic objective of obtaining securities is to recover the unpaid amount of loan if any, through the sale of these securities. Hence, the securities should be clearly identifiable be easily marketable, have stability and their title should be clear and easily transferable.

Types of Securities :-

  1. Personal Securities - These are also called intangible securities. E.g. promissory notes, bills or exchange, a security bond are the personal liability of guarantor etc.
  2. Tangible Securities - These are impersonal security, such as, land, buildings and machinery. If the borrower fails to repay the loan then the bank can sell the asset with the help of court.
  3. Primary Securities - These are those securities or assets which are created with the help of finance made available by the bank, like machinery or equipment purchased with the help of bank finance.
  4. Collateral Security - It is additional security given by the borrower where the primary security is not enough to recover the loan amount at the time of realization, e.g. the land of the factory is given as security along with the machinery purchased out of the bank loan.

Types of Banking

1. Para banking - When Bank provides other banking activities apart from its general banking activities (Deposits and withdrawls)

Services under Para banking :-

  • Debit Card
  • Credit Card
  • Bancassurance
  • Life Insurance Products
  • Cash management
  • Non life Insurance products and etc
2. Narrow Banking - Narrow Banking is also called Safe banking form a bank point of view. When banks invest their fund in government securities instead of investing in market to avoid risk.

3. Overseas Banking – Domestic Banks having branches in other countries besides its origin country . Example SBI, Bank of Baroda has maximum foreign branches by any Indian bank.

4. Offshore Banking – Those banks which are located outside the country of residence of the depositors and provide little or no taxation facility to their customers. A Bank which accepts currency of all countries. Offshore banks are in those Countries which declare them as Heaven Bank Country for ex Swiss Banks.

5. Green banking - Promoting environmental-friendly practices and reducing carbon footprint from your banking activities. This comes in many forms. Using online banking instead of branch banking. Paying bills online instead of mailing them. Opening up CDs and money market accounts at online banks, instead of large multi branch banks.

6. Corporate Banking - Cooperative banking typically serves the financial needs of large corporate houses- both domestic and multinational-public sectors and governments. Corporate banking services include Working capital and terms loans, overdrafts, bill discounting, project financing, Cash management both short term holdings of cash as well as funds held for longer periods, Financing of exports and imports including export credit arrangements.

7. Islamic bank - Those Banks which work according to Islamic Laws. Concept originates in Egypt. Islamic bank opens at Cochin in Kerala in 2010.

8. Kiosk Banking - When we Deposit or withdraw money from booth for ex ATM, ATM Deposit or withdraw Machine, it is called Kiosk banking. It is self-service solutions, allowing customers to service themselves with computer based touchscreen and making different sort of transactions.

9. Defence Banking - Full banking services made available to all members of the Defence force, including non-uniformed personnel and other civilians.

10. Retail Banking - Retail banking refers to the division of a bank that deals directly with retail Customers. Also known as consumer banking or personal banking, retail banking is the visible face of banking to the general public.

11. Banking on Wheel - To provide basic banking services to the remote unbanked villages in the states. It is the part of financial inclusion plan.

Objectives Banking on Wheel :-

  • The branch would be operated on a van. It will be stationed at specific timings of the day in pre - identified, unbanked villages at specified locations.
  • Would be equipped with a GPS tracking system, laptops with 3G connections, LED TV, a safe, a printer, public announcement system, an UV Lamp that detects forged cheques, a note counting-cum-authentication machine that identifies fake currency notes and a unique low- weight ATM.
  • Offers a wide range of banking products and services viz. savings accounts, loans, cash deposit/withdrawal, account balance enquiries, statement printing and funds transfer/DD/PO collections, among others.
12. Merchant banking – Merchant banking refers to specialisation in financing and promotion of projects, investment management and advisory services.

13. Wholesale banking -Wholesale banking is the banking which offers loans and advances to organisations such as Mortgage Brokers, large corporate clients, mid-sized companies, real estate developers and Investors, international trade finance businesses, institutional customers (such as pension funds and Government entities/agencies), and services offered to other banks or other financial institution and they generally deals in bulk sizes loans.

For Chapter-1 "Bank Meaning and their Functions & Structure" - Click Here