What do you mean by CREDIT ? and What are the principles of sound lending ?
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What do you mean by CREDIT? and What are the principles of sound lending?
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- Ans. The word credit is derived from Latin word “Credo” meaning I believe. It is usually defined as ones ability to buy with a promise to pay. From the Bankers point of view, credit is the confidence of the lender on the ability and willingness of the borrower to repay the debt. Credit is the means of investment made by the bank to the entrepreneurs and business community. Alternatively this is the way of channeling fund to the deficit units where various risks and uncertainties are involved.
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What are the principles of sound lending?
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Ans. All lending involves some degree of risk, it is necessary for any bank to develop sound and safe lending policies & new lending techniques in order to keep the risk to a minimum. The principles of sound lending may, therefore, be summarized on followings:
- Safety: Bank mainly uses depositors fund as a means of its earnings & the said funds are being repayable on demand or after a short notice. So, prior lending, a Banker should consider safety of his lending. Safety should never be compromised for profitability. Once the confidence of the depositors is shaken, the banker cannot carry on Banking business. It should be remain in mind of a Banker that advances should be expected to come back in the normal course i.e. the bank may not have to resort legal action or to sell the securities to liquidate the advance.
- The repayment of the loan depends upon the borrowers i). capacity to pay & ii). Willingness to pay. Capacity depends upon his tangible assets & the success of his business. Willingness to pay depends upon honesty and character of the borrower. Liquidity: Liquidity is the availability of Bank’s funds on short notice.
- It is not enough that the money will come back, it is also necessary that it must come back on demand or in accordance with agreed terms of repayment. Liquidity also signifies that the assets should be saleable without any loss. Concept of liquidity has twin aspects, namely, quick sale ability or convertibility of the assets and the absence of risk of loss in such conversion. A sizeable portion of bank advances are therefore, granted to meet the working capital requirement of the borrower rather than to meet fixed capital requirement, i.e. construction of building or purchase of fixed assets.
- Profitability: A Banker has to see that major portion of the assets owned by the Bank are not only liquid but also aim at earning a good profit. The working funds of a Bank are collected mainly by means of deposits from the public and interest has to be paid on these deposits. They have also to meet their establishment charge and other expenses. They have to make provision for depreciation of their fixed assets and also for any possible bad or doubtful debts. Interest earned by a bank against it’s advances is the main source of it’s income. The difference between the interest received on advances and the interest paid on deposits constitutes a major portion of banker’s income. So, the banker will not enter in to a transaction unless a fair return is assured.
- Purpose: A banker would not throw away money for any purpose for which the borrower wants. The purpose should be productive so that the money not only remains safe but also provides a definite source of repayment. Loans are not advanced for speculative and unproductive purposes like social functions and ceremonies or for pleasure trips or for the repayments of a prior loan. A banker must ensure the purpose for which the credit is going to extend because proper utilization of fund & in time repayment of the loan fully dependent on that.
- Security: The security offered for an advance is an insurance or a cushion to fall back upon in case of need. It should be the expectation of a banker that advance will come back from normal sources not to recover the same by selling security. Security serves as a safety valves for an unexpected emergency. An element of risk is always present in every advances & if the securities are not insisted upon, there are chances that the borrower may raise funds elsewhere by charging them to others and thereby bankers position is jeopardized.
- Security taken by banks can be classified in to two broad categories, such as , Primary security & collateral security. Primary Security: Primary security may be either personal security or impersonal security or both.
- Personal security is given by a borrower by way of duly executed promissory note, acceptance/endorsement on a bill of exchange and personal covenants in mortgage deeds or loan agreements.
- Impersonal security is given when a charge is created by way of pledge/hypothecation/mortgage over the borrowers tangible assets such as goods, commodity, fixed assets, bills receivables, book debts etc.
- Collateral Security: Collateral security may be direct or indirect. Collateral security obtained from the borrower himself to secure his own account is known as direct collateral security. For example, advance against hypothecation of stock in trade is strengthen by equitable mortgage of the title deeds of house property of the borrower. Indirect collateral security means any form of security given by a third person to secure a customers account. A guarantee given by a third party is an indirect collateral security.
- Diversity: The advances must not be in one particular direction or to one particular industry because any adversity faced by that particular industry will have serious repercussions on the bank. There should be spread of advances against different securities, industries as well as areas. In a nut shell “all eggs must not put in one basket” so that risk could be mitigated & diversified.
- National Interest: Banking industry has significant role to play in the economic development of a country. Before allowing credit, besides all other principles, Banker must consider national & social interest of that particular credit. Any kinds of profitable advances, which has bad impact on overall economic & social sector of the country, must be avoided. In the changing concept of banking, national interest for financing in some areas, specially in advances to agriculture, small & medium entrepreneurs, small but prospective export oriented industries etc. are assuming great importance.
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