Three cardinal principles of bank lending have been followed by commercial banks in the employment of their funds. These are the principles of safety, liquidity, and profitability.
Safety
The important principle of lending is safety which refers to the important fact that the borrower should be able to repay the loan based on character, capacity and collateral, and business viability. Banks should only lend for productive purposes and the same should not be diverted for speculative purposes or other uses.
Liquidity
Liquidity refers to the capacity of an institution to generate sufficient cash or its equivalent promptly to repay the money to depositors on demand or at short notice. Banks must ensure that they can repay the funds they lend according to a schedule. Therefore the banks must see to it that advances are not locked up but come back immediately. This helps them maintain enough liquidity to meet depositor withdrawals.
Profitability
The amount of money the banks use for lending and investment must generate sufficient profits; hence, profitability is referred to as one of the cardinal lending principles. Banks must focus on the four profit-determining factors: price, volume, variable, and fixed costs. The loan’s interest rate decides the earning capacity of the bank shares and securities.
To learn more about lending principles and practice, read the following post.
