Principles of good lending
The business of lending, which is main business of the banks, carry certain inherent risks and
bank cannot take more than calculated risk whenever it wants to lend. Hence, lending
activity has to necessarily adhere to certain principles.
(a) Principle of Safety of Funds
As the bank lends the funds entrusted to it by the depositors, the first and foremost principle
of lending is to ensure the safety of the funds lent. By safety is meant that the borrower is in
a position to repay the loan, along with interest, according to the terms of the loan contract.
The repayment of the loan depends upon the borrower’s (a) capacity to pay, and (2)
willingness to pay. The former depends upon his tangible assets and the success of his
business; if he is successful in his efforts, he earns profits and can repay the loan promptly.
Otherwise, the loan is recovered out of the sale proceeds of his tangible assets. The
willingness to pay depends upon the honesty and character of the borrower. The banker
should, therefore, taken utmost care in ensuring that the enterprise or business for which a
loan is sought is a sound one and the borrower is capable of carrying it out successfully. He
should be a person of integrity, good character and reputation. In addition to the above, the
banker generally relies on the security of tangible assets owned by the borrower to ensure the
safety of his funds.
(b) Principle of Profitability
Commercial banks are profit-earning institutions; the nationalized banks are no exception to
this. They must employ their funds profitably so as to earn sufficient income out of which to
pay interest to the depositors, salaries to the staff and to meet various other establishment
expenses and distribute dividends to the shareholders (the Government in case of
nationalized banks). The rates of interest charged by banks were in the past primarily
dependent on the directives issued by the Reserve Bank. Now banks are free to determine
their own rates of interest on advances.. The variations in the rates of interest charged from
different customers depend upon the degree of risk involved in lending to them. A customer
with high reputation is charged the lower rate of interest as compared to an ordinary
customer. The sound principle of lending is not to sacrifice safety or liquidity for the sake of
higher profitability. That is to say that the banks should not grant advances to unsound
parties with doubtful repaying capacity, even if they are ready to pay a very high rate of
interest. Such advances ultimately prove to be irrecoverable to the detriment of the interests
of the bank and its depositors.
(c) Principle of Liquidity
Banks are essentially intermediaries for short term funds. Therefore, they lend funds for
short periods and mainly for working capital purposes. The loans are, therefore, largely
payable on demand. The banker must ensure that the borrower is able to repay the loan on
demand or within a short period. This depends upon the nature of assets owned by the
borrower and pledged to the banker. For example, goods and commodities are easily
marketable while fixed assets like land and buildings and specialized types of plant and
equipment can be liquidated after a time interval. Thus, the banker regards liquidity as
important as safety of the funds and grants loans on the security of assets which are easily
marketable without much loss.
(d) Principle of Purpose
While lending his funds, the banker enquires from the borrower the purpose for which he
seeks the loan. Banks do not grant loans for each and every purpose—they ensure the safety
and liquidity of their funds by granting loans for productive purposes only, viz., for meeting
working capital needs of a business enterprise. Loans are not advanced for speculative and
unproductive purposes like social functions and ceremonies or for pleasure trips or for the
repayment of a prior loan. Loans for capital expenditure for establishing business are of
long-term nature and the banks grant such term loans also. After the nationalization of major
banks loans for initial expenditure to start small trades, businesses, industries, etc., are also
given by the banks.
(e) Principle of Diversification of Risks
This is also a cardinal principle of sound lending. A prudent banker always tries to select the
borrower very carefully and takes tangible assets as securities to safeguard his interests.
Tangible assets are no doubt valuable and the banker feels safe while granting advances on
the security of such assets, yet some risk is always involved therein. An industry or trade
may face recessionary conditions and the price of the goods and commodities may sharply
fall. Natural calamities like floods and earthquakes, and political disturbances in certain parts
of the country may ruin even a prosperous business. To safeguard his interest against such
unforeseen contingencies, the banker follows the principle of diversification of risks based
on the famous maxim “do not keep all the eggs in one basket.” It means that the banker
should not grant advances to a few big firms only or to concentrate them in a few industries
or in a few cities or regions of the country only. The advances, on the other hand, should be
over a reasonably wide area, distributed amongst a good number of customers belonging to
different trades and industries. The banker, thus, diversifies the risk involved in lending. If a
big customer meets misfortune, or certain trades or industries are affected adversely, the
overall position of the bank will not be in jeopardy
(f) Principle of Security
The Principle of Security refers to the idea that a loan should ideally be backed by an
adequate and acceptable form of security to protect the bank's interest. This principle ensures
that if the borrower fails to repay the loan, the bank can recover the amount by realizing the
value of the security provided. The security acts as a secondary source of repayment, while
the borrower’s ability to repay from their own funds or business remains the primary source.
The value, marketability, and legal enforceability of the security are crucial—banks prefer
assets that can be easily liquidated and legally claimed in case of default. However, it’s
important to note that security is not a substitute for creditworthiness—even for secured
loans, banks first assess the borrower’s financial health and repayment capacity before
approving the loan.
(g) Credit worthiness of borrowers
The creditworthiness of a person means that he deserves a certain amount of credit, which
may safely be granted to him. Such creditworthiness is judged by the banker on the basis of
his (1) character, (2) capacity, and (3) capital (4) Collateral and (5) Conditions
Character is the foremost consideration. It reflects the borrower’s honesty, integrity, sense
of responsibility, and commitment to fulfilling obligations. A person with a good
reputation, who has consistently repaid previous debts on time and is known for ethical
behaviour, is likely to be trusted by bankers. The presence of strong moral values and
reliability significantly increases the chances of obtaining an unsecured loan.
Capacity refers to the borrower’s competence, skills, and experience in managing the
proposed business or trade. Even in the absence of collateral, a borrower with sound
technical knowledge, managerial ability, and a solid business plan may be seen as a
deserving candidate. Banks often place great emphasis on this factor, especially when
financing professionals and entrepreneurs who demonstrate potential for success.
Capital represents the financial strength and personal investment of the borrower. While
the loan itself is unsecured, banks still expect the borrower to have sufficient funds of
their own invested in the business. This gives confidence that the borrower is serious and
has something to lose in case of failure. In situations where the business fails, the
borrower’s own capital provides a cushion for repayment.
Collateral: This refers to the asset(s) a borrower can offer as security for the loan. While
unsecured loans don’t involve collateral, in general lending practices, collateral gives the
bank a fallback option if the borrower defaults. It reduces the lender’s risk and can
influence the amount and terms of the loan.
Conditions: These are the external factors and terms surrounding the loan, like the
purpose of the loan, the current economic environment, industry trends, and government
policies. Banks also consider conditions like interest rates, inflation, and regulatory
factors that might affect the borrower’s ability to repay.
