Principles of Lending Followed by Banks

Principles of Lending Followed by Banks

Introduction

The money that the bank provides when demanded is in layman’s language stated as advances. Further breaking down the concept of advances comes into the terminology of Loans that is also very similar to the activity done by banks while providing money on demand. The money that is granted, it is given to the customers of the bank and can be either secured or unsecured totally depending upon the bank and their set of principles. But one thing that remains common in all the banks is the mean of taking interest upon the provided loans to the customers as the major part of the bank’s income is out of the interest earned by the banks on providing the money.

The lending of money is done by the banks by the deposits that they intake from the public or their own customers. Which further in as a whole process involves various kinds of risk and threat to the tangible assets of the bank itself. The risks that the banks’ witness is majorly related to the credit flow that takes place when the amount lent is not coming back as expected. With said that, there also comes a risk that is operational in nature and solely depending upon the market and liquidity.

Therefore, the banks in overhand take care of the prudent risks by managing the entire risk by various measures that focus on improving the profits and lesser further losses upon loans and investments respectively. Henceforth the only solution that comes up in the way to decrease the risk is to include all kinds of assets and practices, especially that are prudent in nature and improve the operating system by managing principles for lending out money.

Principles of Lending that are followed by banks are herein
Safety of funds

The Safety of funds stand very important when the bank follows the procedure of lending because the money that banks lend, comes from the public, so safety is the first concern of all the banks that mandatorily takes place. The banks ensure that money is in safe hands and will come back as agreed with interest and without any default. Safety mainly comes from the character of the borrower, the capacity of the borrower to do the business, and his stake involved in the business. Besides this, the nature of security offered by borrowers to the bank is of utmost importance.

Liquidity

Liquidity [1]refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price. This is because the major portion of bank deposits is repayable on demand or at a short notice. Bank has the procedure of granting loans on the security of assets which are easily marketable without much loss of time and value.

Profitability

Profitability marks its way in the process of lending because banking is a business and any business survives and grows only on profits. Bank incurs expenses to maintain deposits such as interest, rent, stationery, infrastructure, etc. Such expenditure needs to be recovered and that is done out of the profit-making process. The sound principle of lending is not to sacrifice safety or liquidity for the sake of higher profitability.[2]

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Purpose

The purpose of the loan should be productive. Productivity ensures an increase in sales and the realization of sales proceeds generate additional income from which repayment of loan installment with interest is made. Banks lend money for consumption purposes as well, for instance for purchasing consumer durables, where repayment comes from the fixed income of the borrower. Loans are not advanced for speculative and unproductive purposes[3].

Spread 

Spread or termed as diversification avoids the risk of concentration. Banks lend money under different facilities such as term loan, cash credit, overdraft, bills, etc., for different purposes like business, housing, education, etc., to different industries like cement, pharmaceutical, agriculture, steel, IT, trade, etc., in different geographical areas and so on to spread the risk. In short, banks should follow the principle of “Not putting all the eggs in one basket.”

Security

Securities against which banks lend must be marketable, ascertainable, stable, and transferable. The borrower should have a clear and transferable title over the security given to the bank so that if required can be effectively sold in the market by the bank.

Conclusion

The lending of money is done by the banks by the deposits that they intake from their customers. Which involves various kinds of risk and threat to the tangible assets of the bank. The risks that the banks’ witness is majorly related to the credit flow that takes place when the amount lent is not coming back as expected. There also comes a risk that is operational in nature and solely depending upon the market and liquidity. Therefore, the banks in overhand take care of the prudent risks by managing the entire risk by various measures that focus on improving the profits and lesser further losses upon loans and investments respectively. Henceforth the only solution that comes up in the way to decrease the risk is to include all kinds of assets and practices, especially that are prudent in nature, and improve the operating system by managing principles for lending out money. The risk management process is taken care of by the lending process that involves the Safety of funds, the process of liquidity & profitability, and the steps that involve the purpose of lending, the spread of it, and the security regarding it.

Principles of Lending Followed by Banks

Also Read: Advantages of the Insolvency and Bankruptcy Code, 2016


[1] Definition of Liquidity: https://www.investopedia.com/terms/l/liquidity.asp

[2] https://www.scribd.com/presentation/256716941/asset-mngmnt

[3] http://www.articlesfactory.com/articles/finance/no-credit-check-auto-loans.html

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