Bank’s loan products is a very sensitive area of operation. There are six basic principles of lending that have been followed by banks since long. These principles are Safety, Liquidity, Profitability, Purpose, Diversification of Risks and Security. Each bank is having its own internal guidelines to ensure that the basic principles of lending are followed. However, though the products may vary in their names, the Asset products which are almost common to all banks.
Basically, Banks are required to lend 40% of advances to `Priority Sector’, 25% of which should be lent to `Weaker Section’ in terms of Reserve Bank of India guidelines.
Fund Based and Non-Fund based lending
Broadly, the lending function can be Fund Based or Non-Fund Based. As the name suggests, Fund Based Loan product Facility involves actual outlay of Cash from Bank to the Loan Borrower who needs the fund for personal or business activity. There are various types of loans and we shall learn about the same in due course. Let’s understand the concept of Fund Based Lending, below is the classification.
- Fund Based Credit Facilities – Direct Loans to customer
- Non-Fund Based Lending – Bank Guarantee & Letter of Credit
Types of Fund Based Credit
In practice, the operations in cash credit facility are similar to those of overdraft facility except the fact that the company need not have a formal current account. Here also a fixed limit is stipulated beyond which the company is not able to withdraw the amount. Legally, cash credit is a demand facility, but in practice, it is on a continuous basis. Interest is payable on amount actually availed, and is calculated on a daily product basis.
Bills Discounting/Bills Purchase
This form of assistance is comparatively of recent origin. This facility enables a company to get immediate payment against credit bills raised by them. The bank holds the bill as a security till payment is made by the customer. The entire amount of bill is not paid to the company.
The Company gets only the present worth of the amount of bill, the difference between the face value of the bill and the amount of assistance being in the form of discount value. On maturity, bank collects the full amount of bill from the customer. While granting this facility to the company, the bank inevitably satisfies itself about the credit worthiness of the customer. A fixed limit is stipulated in case of the company, beyond which the bills are not purchased or discounted by the bank.
Working Capital Term Loans
To meet the working capital needs of a company, banks grant working capital term loans for a period ranging between 3 to 7 years, payable by yearly or half yearly installments.
This type of assistance may be considered by banks to take care of specific needs of the company when it receives some export order. Packing credit is a facility given by a bank to enable the company to buy the goods to be exported. If the company holds a confirmed export order placed by the overseas buyer or a letter of credit in its favor, it can approach the bank for packing credit facility.
Buyer’s / Supplier’s Credit
These are similar to Bills Discounting / Bills Purchase. A manufacturing venture requires such types of Credit facilities, which are self-liquidating in nature. These facilities are more relevant to Financing of Foreign Trade: Imports & Exports
Term loans are a type of long-term loans that can last anywhere between one year to thirty years. It is repaid throuh regular payments at a fixed or floating interest rate. Term loans are sanctioned for acquisition of fixed assets like land and building, plant and machinery, equipment and furniture fixtures, vehicles etc.
Banker has to ensure the end use of the amount lent and hence amount lent is directly given to the supplier of the fixed asset and proper invoice is obtained for record. Banks have been financing new business ventures and also have been funding the total financial needs, including term loans of both new and existing units of all sizes. The company / firm has to provide margin money through company’s capital to get the loan whereby the cost of project is partly funded through own funds (called margin) and the balance through borrowing from financial institutes like banks
Working Capital Facility
Working Capital facility is the credit taken out for a short term, usually for a year renewable periodically, for financing the day-to-day operations of a company. This working capital is used to fund the employees’ salaries, accounts payable, raw materials, advertising etc.
In case of working capital finance the stock of material purchased through the finance from banks, the outstanding gets cleared from the proceeds of sale of finished goods and thus working capital finance is self-liquidating through the completion of operating cycle and is a continuous process.
Whereas the term loan once paid off through the profits of the business is not raised for the same purpose. When Term Loans are given the repayment should be feasible from the profits of the company.
Non-Fund based credit facilities
Non-Fund based Credit facilities do not involve actual fund flow from bank to customer, ie, there is no credit extended to the customer. It is a sort of assurance or security to the third party involved in a transaction on behalf of its customer that in the event thef customer fails to pay back the dues, Bank takes the onus for the same. The Non-Fund based Loan Facilities provided by banks are:
Bank Guarantee (BG)
In a BG or Bank Guarantee, the bank gives a commitment in the approved format on behalf of its customer to a third party, for a fixed sum of money for a fixed period of time. The bank charges the customer a percentage of that amount as commission (normally near about 3%p.a.).
The bank doesnot have to part with any money. However, the liability arises as and when the customer defaults on payments. The banker makes good the loss of money as per the guarantee contract, which is called invocation of guarantee by the beneficiary. Banker then recovers this money from the customer on whose behalf the guarantee was issued. Part of the BG is secured by margin money and balance is secured by collateral security like immovable property or stocks and book debts or any tangible asset.
Customers can avail services or buy goods without borrowing money which means they don’t have to pay interest either. Customers can also service contracts or obtain contracts without borrowing interest-heavy funds.
Letters of Credit (L/C)
LC is an integral part of all import and export transactions. The Letter of Credit helps the seller to get his money from the buyer living in another City or Country. LCs can either be inland or foreign.
Generally, in an international trade, seller may not be willing to sell the goods to the buyer unless he is certain about payment. The risk in dealing with unknown buyer can be very high. The buyer may not retire the bill in which case the seller has to incur substantial expenditure for finding an alternate buyer, import of goods etc. So, seller wants an assurance that he will be paid in full within the agreed time.
Similarly, a buyer wants an assurance that he does not have to pay the seller until he is certain that a seller has fulfilled his obligations as per agreement. Under these circumstances, banks issue an LC or letter of credit to facilitate the payment of the trade transactions.
The main documentation required to avail L/C are:
- Value of Raw materials consumed and of which on credit from supplier.
- Time taken for reaching L/C to the beneficiary
- Time for shipment & consignment to reach customer’s destination
- Usance period granted by the seller to the buyer
- The entire time taken from issue of L/C to retirement of L/C and MPBF workings
Risks involved in Lending and mitigation processes
- If staff misjudge either the business or the borrower, it is difficult to fix the problem once the loan is granted.
- Careful evaluation of the business viability and borrower character are essential to lending unless the organization can rely on (a) collateral, (b) cross-guarantees within a group of borrowers, or (c) social pressure networks.
- While alternatives to traditional collateral have worked well in certain developing countries, they have worked less well in other countries
- Prudent judgments of business viability and borrower character are essential.
Priority Sector Lending:
The PS advances relates to the facilities granted to
- Agriculture (Direct and Indirect)
- MSME (Micro Small and Medium Enterprises)
- Small Business
- Retail Traders
- Professional and self employed
- Education Loan
- Vehicle Loan
- House/Home Loans
- Mortgage Loans
- Small and Water Transport Operators
- Loan to Weaker Sections
Also, the Retail Loan sector is growing these days very fast, which include, Consumer Loans, Salary Loans, Personal Loans, Credit Card Loans and Retail Sectors. The Indian Loan market through banks and non banking financial companies have grown multi-fold during the last decade and the growth is still continuing.