Principles of Lending: Comprahensive framework and practice

The principles of lending revolve mainly around the concepts of safety, profitability and liquidity of advance. The criteria for lending get changed or modified from time to time in response to changing the state of the economy. Traditionally commercial banks in India used to provide security oriented finance to trade and industry. Big industrial houses and traders were beneficiaries of the security-oriented lending concept and a large chunk of bank finance was enjoyed by them. The concept of lending radically changed in 1969 after the nationalisation of fourteen commercial banks.  The concept of security-based bank finance changed to the concept of need-based finance, albeit wherever collateral securities are available continued to be accepted. Thus the focus is on the viability of the project while entertaining the credit proposals and not merely on the availability of security. However basic principles that govern bank lending remain unchanged on safety, profitability and liquidity of advance.  Banks all over the world scrutinise the following details with care before acceding to a loan request.

Identification of borrower: Selection of a borrower is the most important factor to be considered at care. There are numerous instances of parties indulge in various types of frauds and forgeries to cheat banks and avail finance. Banks can avoid most of such instances by sticking to principles of KYC (Know Your Customer) in letter and spirit. While entertaining new proposals, as a matter of rule and without fail, caution advice and defaulter list of RBI/ECGC caution list/CIBIL Report/Reports from other banks must be verified.  Trade circle enquiry, information from Newspapers and magazines may sometimes supply important information which is a matter of concern to the bank. Since the safety of funds lent will be the main concern of a bank, the advance should be granted to a reliable borrower who can repay the loan in the ordinary course of business.

The Purpose of loan:  The proposal maybe for a new venture or for expansion or diversification of existing unit or for a renewal/ revival/ enhancement of existing limits. Though the request for advance may be safe and secured, still bank should concentrate on whether the advance is for productive purpose and it is needed for legitimate activity from the standpoint of Government guidelines. 

Quantum of Loan: A prudent banker ensures that finance made available to the borrower is neither over financed nor underfinanced.  Inadequate finance kills the project and thereby sinks the bank finance. Over finance enables the borrower to divert the funds for activities other than the purpose he had availed the facility, which ultimately jeopardises the repayment plan. Hence proper appraisal is a must before sanctioning a quantum of loan or credit limit.

Period of Loan: A Bank would remain liquid if its advances are also liquid. A type of loan and maturity pattern bank entertains is essential for its asset-liability management. The repayment period (short/long term) fixed on loans shall be adequate to match the demand of depositors. 

Source of repayment: The repayment of advance is of paramount importance to a bank. When a borrower approaches the bank for finance, he must have a clear idea of how he is repaying the loan/advance and indicate the same to the bank. The source of repayment may be from income generated out of business/salary or any other source. In the cases of working capital account like Cash Credit or bills purchase/discount facilities, it may be self-liquidating on the realisation of sale proceeds.

Security for advance:  The type of security offered to the bank is an important criterion while entertaining a loan proposal.  The prime security can be hypothecation/pledge of stock, book debts or other assets created out of bank finance. Bank may insist on a charge on immovable property as collateral security in addition to prime security and a third party guarantee (which is also treated as security to bank finance). The main concern is that security available to the bank should be good enough to fall back upon in the event of adverse circumstances. The value of security accepted should be steady and easy to ascertain. All precaution to be taken while accepting the immovable property as security that the security offered has a clear marketable title. It is also inevitable to ascertain and confirm through legal opinion from an experienced advocate so that bank could easily take possession of such security with very little expenses and dispose-off the same to recover its dues when the account goes bad.

Profitability: Credit risk is always associated with any type of lending Interest rate charged to an advance must be commensurate with the risk entailed, the amount of work and also expenses involved in the facility.

Pre-Sanction Inspection:

The branch Manager should visit the borrower at his place of business and make the preliminary report on the prime/collateral security offered. The purpose is to see that the business exists at the address given. It is also useful to ascertain the infrastructure available and the level of activity of the unit. Further, it helps the Manager to familiarise himself with the borrower’s business and attendant trade practices.

Appraisal of credit proposal:

Poor quality of credit appraisal both technical and financial viability, contribute to the accretion of Non-Performing Assets (NPA). Accepting unrealistic projection and fixing an unduly short repayment schedule may cause problems at the time of recovery. The credit officer would consider all the information collected from internal and external investigation sources to support the credit decision. Promoter’s educational, professional qualification, experience, management capability, history of payment record and fulfilment of financial obligations etc, are a matter of importance while appraising the proposals. The general documents, apart from the exclusive set of financial papers which depends upon the nature of finance, required by banks are as under. 

In conclusion, appraisal of credit proposal can be called as the assessment of the Techno-economic feasibility of the business and also satisfying ‘Three C’s of the borrower i.e. the Character of the borrower, Capital/margin brought by the borrower and his capacity to run the business. The appraisal should also be free from Complacency, Carelessness, Communication gap and unhealthy Competition. 

Sanction: The essence of a sanction is adequate credit given to a borrower in time. Bankers should be sensitive to the difficulties of the borrower. Many a time, we hear that Credit officers/Managers do not exhibit a sense of urgency while considering the borrower’s request.  Although it is necessary to function within the broad framework provided by the bank for credit assessment and disbursement, the sanction should not be delayed under the guise of rules and regulations.

Documentation: The execution of documents according to the law in the proper form is called documentation. Documentation is the most important part of bank lending.  The role of documentation is to establish a legal relationship between the lending banker and borrower when the dispute goes to the court of law. The official in charge must be thoroughly conversant with the type of securities and legal nature of charges to be created while preparing the documents. 

Stamping: Under section 17 of the Indian Stamp Act 1899, all the documents chargeable with stamp duty shall be properly and duly stamped before or at the time of execution in India. In the cases of Demand Promissory Note (pro-note), acknowledgement of debts, bill of exchange etc, if under stamped, is ab-initio void and same can not be admitted in evidence even by paying penalty. The revenue stamps on the document should be effectively cancelled at the time of execution. The best way of cancelling of revenue stamp is by the sign over all the stamps in such a manner that the signature extends even beyond the stamps. 

Execution: The document should be executed in the presence of the Manager/Authorised official of the bank. The documents should not be given to the borrower for obtaining signature/s from other borrowers or guarantors. The documents should be executed in one sitting and also ensure that the executants read the content of documents prior to execution. The borrower should sign in full on all the documents and not by initials. The cutting, overwriting, interlineations must be authenticated under the full signature of the executants/s. Any instrument chargeable with stamp duty executed out of India must be stamped within 3 months after it has been first received in India.

Attestation: Attestation means witnessing the execution of a document that is required to be attested under law. In the case of documents like the assignment of LIC policies one witness is required and in the case of mortgage deed there should be two witnesses. Some documents like demand promissory note need not be attested. The executants are the party to the deed and they should not be attesting persons. The attesting person need not know the contents of the document.

Registration of Mortgage/Memorandum of mortgage: In the case of mortgage deed or memorandum of title deeds to be registered the original deed must be presented for registration with Registrar of Assurance (Commonly known as Sub-Registrar office) under whose jurisdiction property is situated. The registration should be done within four months of execution of documents.

Registration with Registrar of Companies (ROC): In the case of limited companies, the charge on the company’s assets like hypothecation of stocks and machinery, book debts, mortgages etc shall be recorded with ROC within 30 days of execution of documents in terms of Sec.125 of the companies Act. The registration should be done with the Registrar of Companies under whose jurisdiction the company’s Registered Office is situated.

Post disbursement follow up: Direct payment shall be made towards goods/machinery purchased as per invoice made by way of demand draft in favour of the supplier. It is wrong to credit the loan proceeds to the borrower’s SB/CD account, as it is observed that many a time bank finance was diverted by the borrower for the purpose other than the loan was actually sanctioned. The inspection shall be conducted for the purpose of ascertaining the end-use/creation of assets from bank finance. Care shall be taken by the inspecting official that old/defunct machinery are not shown to him as new machinery. Bank’s board of hypothecation/pledge shall be prominently displayed where the stocks/machinery are placed. The working capital limits sanctioned, are usually valid for one year, hence proposals for ‘Renewal /Enhancement of limits’ should be taken up well in time. The documents obtained while releasing the limits shall be properly maintained, revival letters, acknowledgement of debts etc. to be obtained at the periodical interval, to keep the documents alive. An asset created by bank finance shall be fully insured with a bank clause. In some cases, the company holds inventory over and above the working capital limit and go for insurance only to the extent of credit limits. Banks shall not accept such proposal of the borrower, as it amounts to under insurance. In such an event of under insurance, the insurance company will settle proportionately to the extent of total stock holding vis-à-vis insurance cover although damage claimed is within the insurance coverage amount. In view of avoiding claim complications banks normally insist on comprehensive insurance for not less than 120% of the inventory holding.

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