Loan Policy of a Banks

Historically, most of the large banks as we see today have had a

modest beginning and catered to the needs of the ethnic community of
the place where it started its business. Their activities were regional in
nature, with relatively simple operations of mobilising deposit and
making loans to the businessmen of their choice.

The banks did not have any documented loan policy as it was
considered to be a hindrance for business growth. The business of
giving loans was left to the absolute discretion of the Board of
Directors and other managerial executives of the bank. A loan policy
as a written document did not find favour with a large number of
bankers on the grounds that it will stand in the way of flexibility in
lending decisions.

However, the deregulation of the financial market and its movement

towards global integration, together with the imposition of prudential
norms like capital adequacy and stricter provisioning requirements,
have made it imperative to have a well-documented policy framework
for a bank for its lending activities.

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The absence of a well-defined loan policy had often induced the banks
to go for reckless growth of their loan portfolios without observing the
prudential norms of spreading the risk by lending to different sectors
of industry, trade and commerce. Initially, the banks would hardly
finance the agricultural activities and other economic needs of the
weaker sections of the society.

Basically, the performance of the financial and the banking sector is

dependent on the performance of the real sectors of the economy. Real
sectors include the economic activities of the agricultural,
manufacturing and trading sectors of a country. It is, therefore,
imperative that formulation of a loan policy of a bank must be
preceded by a strategy analysis of the financial management of the
borrowing customers, who primarily belong to the real sectors. Thus,
the loan policy of a banking organisation has to flow out of its strategic
planning.

Elements of lending policies are primarily drawn from the strategic

plan of a banking organisation. The planning is based on various
assumptions and the target for different types of lending is set
accordingly. The principal objective of a loan policy is to make out a
strategy for maximising the returns or profit and minimising the risks.

Along with maximising the profits the lending policy should

also cover the objectives of:
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(i) Maintaining an adequate capital base for growth and regulatory

requirements; and

(ii) Conducting the lending function within a managed framework of

risk analysis.
With the process of disintermediation and financial and banking
sector reform, the commercial banks are confronted with formidable
competition. The deregulation of the interest rate has made the
competition even more cutthroat. Under the circumstance, banks have
to look for other avenues of income generation, particularly the more
and more non-fund business for fee-based earnings. In order to ensure
growth in revenues, the banks have to rely substantially on non-
funded business like opening of letter of credit, issuance of bank
guarantees, selling of third party products, viz., mutual fund,
insurance, etc.

With the kind of transformation that is taking place in the banking

industry, it has become necessary for the banks to be conscious of
their earnings and asset quality. Since profit is a reward for the risk-
bearing capacity, the spread between cost of fund and yield on
advances available in case of high quality loan assets is getting thinner
day by day. Therefore, there is a need for a bank to judiciously
complement its priority of the quality of the loan assets with that of
profit maximisation.

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The loan policy should govern all credit and credit-related exposures,
fund-based as well as non-fund-based. These would include short-
term, medium-term and long-term fund-based facilities, as also the
non-fund-based business and the exposures in the foreign exchange
market, if any. The policy should also be applicable to the banks’
investments in money market and the market for stocks and debt
instruments.

The loan policy should encompass all types of customers from various
segments such as individuals, proprietorship and partnership firms,
trusts, societies and association of persons, companies and corporates,
both in the private and the government sector.

The loan policy should focus on the directed finance such as the
priority sector lending in India as well as the advances to the small and
medium enterprises and other large commercial houses. There should
be a clear-cut policy for financing to the retail sector, comprising
personal loans, education loans, housing loans, mortgage loans, etc.

The loan policy framed by a bank is subject to modification from time

to time, depending on the overall economic and business environment
in the country and the world at large. The bank’s low priorities for
lending should be clearly advised to the loan officers for their
implementation. A well-documented Loan Policy restrains reckless
financing by the bank’s executives who have the instincts for taking
the bank for a ride.

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By granting loans and advances, the commercial banks add to the

money supply in the country. Hence, it is said that banks create money
and add to the deposit in the banking system. Whenever a commercial
bank lends any amount to a customer, the money lent is either
deposited in an account of the customer for his use or it is disbursed
by paying directly to the beneficiaries who had supplied the goods or
services to the bank’s customer.

The recipients of the disbursed money deposit them in their accounts

with other banks. Therefore, in both the cases, the initial loan given by
the bank has created more money by way of deposit either in the same
bank or in other banks and the said deposit can be used to extend
further loans after keeping the necessary reserves together with what
is required to meet the demand for cash withdrawal by the depositors.

Banks know from their experience that all the depositors do not come
at the same time for withdrawal of their entire deposit, and at any
point of time the quantum of money required to for meeting the
withdrawal demands does not exceed 10% of the total deposits. This
induces the banks to lend 90% of the deposits, which create further
money and deposit. This is called the Multiplier Effect of Bank Loans,
which acts as a propeller for the economic growth of a country.

Since the banks deal with public money in the form of deposits, they
have to exercise several precautionary measures so that the money
lent can be recovered with interest and other costs related thereto.

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Banks, therefore, have to ensure the following:

Safety:
Banks have to ensure the safety of the funds lent by them as the very
existence of a bank depends on recovering the amount with interest.
Reckless lending is likely to land the bank in deep trouble that may put
the bank in liquidation.

Liquidity:
A major part of the deposit mobilised by the banks is payable on
demand. Hence, banks cannot afford to lock-in their funds for a very
long term or on a permanent basis. Banks are required to consider the
liquidity of the funds as far as possible so that, if needed, they can get
back the money by recalling the advance, wherever warranted.

It is not the function of commercial banks to make loans which are

more or less of a permanent nature, though often the banks give loans
on medium- term basis to manufacturing projects, the infrastructure
sector, etc. Traditionally, the banks cater to the working capital
requirement of the business enterprises which is recycled within a
short period, depending upon the nature of the business cycle of the
enterprise.

Purpose of the Loan:

Banks have to be fully aware of the purpose or end-use of the loan
required by the borrower. It is imperative for the bank to know
whether the borrower will be able to repay the loan by using the
money for the purpose stated at the time of availing of the loan. In
short, the banks have to ensure the economic viability of the purpose
to which the loan will be put to.

Though loans are generally repayable by the borrower on demand,

there may be instances where the borrower is allowed to use the funds
for a specific period and the repayment is spread over a period by
instalments.

It is important for a bank to have a diversified loan or credit portfolio,

so that all the funds lent by the bank are not concentrated in one or
two segments of the economic activity. The bank’s fate should not
fluctuate with the ups and downs in the performance of a particular
segment of the industry. The cardinal principle here is ‘do not put all
the eggs in one basket’.

Security:
Though security cannot be the only criterion for granting loans and
credit by banks, its importance also cannot be undermined. Security is
only a cushion to ‘ fall back upon, in case the borrower fails to repay
the loan in the normal course of events. Adequacy of security alone
cannot be the sole consideration to determine the suitability or
creditworthiness of the borrower.

Banks would like to realise their dues in the normal course of business
from the normal business operation of the borrower – rather than
realising their dues by disposing of the security offered by the
borrowers. Moreover, selling the security is often time consuming, and
associated with attendant costs.

The security offered against loans and advances is vast. It generally

includes stocks in the form of raw material, finished goods, work in
progress, sundry debtors, plants and machineries, land and buildings,
cash deposits with banks, gold, shares of companies and other paper
securities. More often than not, the banks obtain the security of the
personal properties of the promoters, directors, partners and other
owners of the business enterprise.

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The security offered by the borrower should possess the

following qualities:
(i) Marketability Banks must ensure that the securities offered are
easily saleable, without much discount or reduction in their value at
the time of offer to the bank. Value of security in the form of shares
and bonds of companies lodged with the bank is sometimes volatile
and a substantial part of the value may be wiped out in the event of
liquidation of the relative company. Government bonds or other gilt-
edged securities are considered to be very safe in this regard.

(ii) Stability of Price Since the primary objective of the bank is not to
make windfall profit from the disposal of the securities, banks
normally like to see that the prices of the securities offered are, by and
large, stable. Speculation in the price of the securities cannot be the
motive of the bank.

(iii) Free from Encumbrance Before accepting any security, banks

have to ensure that it is an unencumbered asset, and no other person
or entity has got any charge over the said asset.

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The borrower is the most important security. If the borrower is a man
of commitment, he will repay the loan by any means.

Total dependence of the bank on security without evaluating the

creditworthiness of the borrower is often fraught with the chance of
running into difficulties. If the borrower is a man of integrity, even if
his business fails, he will go all out to repay the loan.

On the other hand, if the borrower is indifferent in regard to

repayment of the loan, the bank will have to fall back upon the security
offered, and a distress sale of the security may not fetch the adequate
amount to square off the loan, and thereafter, initiation of legal action
for recovery will entail a long-drawn and expensive process in or
outside the court. There is an old saying often used by the bankers, ‘a
first class borrower with second class security is much safer than the
second class borrower with first class security’.

Therefore, the borrower is more important than the security

and while appraising a loan proposal, the following four ‘C’s
of the borrower have to be carefully examined:
Character:
The character of the borrower shall indicate whether he is a man of
words or his commitment. Who is the borrower and what is his family
background are important aspects to be considered by the bank. Is
there any report of the borrower not honouring his commitment?
What is the state of his relations with his co-businessmen and the
other persons involved in his business? A bank must endeavour to
ascertain whether the borrower is a respectable person who
understands his responsibilities and conducts his business prudently.

Capacity:
The capacity of the borrower refers to his ability to conduct his
business prudently and to generate adequate surplus to repay the
advance.

While making an assessment, the bank has to consider the

following points:
1. Whether the business is new or an established one

2. The borrower’s experience in the line of his business and whether he

has the required knowledge of the relative activities or he is going to
run the business by employing professional managers with the
required technical know-how

3. The marketability of the product to be manufactured or dealt with

by the business

4. Whether the borrower has the ability to run the business efficiently
and meet his competitors

Capital:
A prudent banker should see that the borrower has a reasonable
amount of capital and he does not intend to run the business entirely
on borrowed money. The capital employed by the borrower will
provide his margin towards acquiring assets by way of stocks in trade,
plant and machinery, land and building, etc. Capital may be in the
form of cash or assets, e.g., land, building, plant and machinery.

Collateral:
Assets created out of the loan amount form the primary security for
the credit facility given by the bank. Apart from the primary security,
any other property offered by the borrower as security is known as the
collateral security. Availability of adequate collateral security adds to
the creditworthiness of the borrower and the lending bank also gets an
additional comfort factor in order to consider the loan requested.

Besides the four Cs mentioned above, whenever a

prospective borrower approaches the bank for a loan
facility, the bank should endeavour to ascertain the
following points, preferably through a personal interaction
with the prospective borrower:
(i) Details of the business – constitution of the business and its year of
establishment, who are the promoters, the business’ position in the
market, the products dealt with, etc. The amount of investment by the
promoters in the form of capital, together with the working results for
the last two or three years, should also be asked for.

The economic viability of the business activity to be financed must be

ascertained. Viability of the business is most crucial, as otherwise,
generation of profit and repayment of interest and the principal
amount will be uncertain. The issue of viability of the business is at the
core of the appraisal process and if the business is not economically
viable and technically feasible, there is hardly any need to proceed
further for the proposed loan.

For the purpose of establishing the economic viability and technical

feasibility, if needed, the bank can avail of the opinion of the relative
experts in the field. The entire business activity hovers around the
projected sales, which should be achievable and realistic.

Considering the competition in the market for the said product and
the technical know-how available to produce the same, it should be
ascertained whether the amount of projected sales is reasonable or
not. Wherever necessary, the use of the market research groups or the
concerned technical experts may be resorted to.

(ii) Why does the borrower need an advance and how was he
managing so far? What is the exact purpose for which the loan is
required?

(iii) What are the present liabilities – both his personal and of the
business?

(iv) What are the details of the properties owned by him? Is there any
loan against them? Names of referees, including existing banks,
should also be obtained.

(v) What is the amount of loan required and how has the borrower
arrived at the required loan amount?
(vi) What are the securities that the borrower can offer, together with
their market value?

(vii) How does the borrower propose to repay the loan?

The above information obtained by the bank should be verified from

various sources. This process, known as credit investigation, is
essential to establish the creditworthiness of the borrower. The
information furnished by the borrower shall be supplemented by
market reports about the borrower, his income tax, sales tax and
wealth tax returns. If the borrower has accounts with other banks, a
status report from the said banks should also be obtained.

Collecting the above information is a part of the credit appraisal

process, and to take a view on the information furnished, the bank has
to proceed for a pre-sanction inspection, which is one of the most
crucial parts of the decision-making process. The particulars already
furnished by the prospective borrower need to be verified as far as
possible by inspecting the place of business and other assets offered as
security by the borrower.

Wherever the loan asked for is proposed to be guaranteed by a

guarantor, a personal interview with the guarantor and inspection of
the guarantor’s property if offered as security is also necessary. The
worth of the guarantor and his capacity to guarantee the loan has to be
ascertained. If the guarantor is an outsider, his interest in extending
the guarantee should invariably be ascertained.
 Bank Management - Formulating Loan
Policy
Basically, loan portfolios have the largest effect on the total risk profile and
earnings performance. This earning performance comprises of various
factors like interest income, fees, provisions, and other factors of
commercial banks.

The mediocre loan portfolio marks approximately 62.5 percent of total

centralized assets for banking organizations with less than $1 billion in total
assets and 64.9 percent of total centralized assets for banking organizations
with less than $10 billion in total assets.
In order to limit credit risk, it is compulsory that suitable and effective
policies, procedures, and practices are developed and executed. Loan
policies should coordinate with the target and objectives of the bank, in
addition to supporting safe and sound lending activity.

Policies and procedures should be presented as a layout for all major credit
decisions and actions, enclosing all material aspects of credit risk, and
mirroring the complexity of the activities in which a bank is engaged.

Policy Development
As we know risks are inevitable, banks can lighten credit risk by
development of and cohesion to efficient and effective loan policies and
procedures. A well-documented and descriptive loan policy proves to be the
milestone of any sound lending function.

Ultimately, a bank’s board of directors is accountable for flaying out the

structure of the loan policies to address the inherent and residual risks.
Residual risks are those risks that remain even after sound internal controls
have been executed in the lending business lines.

After formulating the policy, senior management is held accountable for its
execution and ongoing monitoring, accompanied by the maintenance of
procedures to assure they are up to date and compatible to the current risk
profile.

Policy Objectives
The loan policy should clearly communicate the strategic goals and
objectives of the bank, as well as define the types of loan exposures
acceptable to the institution, loan approval authority, loan limits, loan
underwriting criteria, and several other guidelines.

It is important to note that a policy differs from procedures in which it sets

forth the plan, guiding principles, and framework for decisions. Procedures,
on the other hand, establish methods and steps to perform tasks. Banks
that offer a wider variety of loan products and/or more complex products
should consider developing separate policy and procedure manuals for loan
products.
Policy Elements
The regulatory agencies’ examination manuals and policy statements can be
considered as the best place to begin when deciding the key elements to be
incorporated into the loan policy.

In order to outline loan policy elements, the bank should have a consistent
lending strategy, identifying the types of loans that are permissible and
those that are impermissible. Along with identifying the types of loans, the
bank will and will not underwrite regardless of permissibility. The policy
elements should also outline other common loan types found in commercial
banks.

The major policy elements for a bank are −

 A statement highlighting the features of a good loan portfolio in terms of types,

maturities, sizes, and quality of loans. In short, a goal statement for entire loan
portfolio.

 Stipulation of lending authority prescribed to each loan officer and loan

committee. The main task of loan officers and loan committee is to measure the
maximum amount and types of loan approved by each employee and committee
and what signatures of approval are needed.

 Boundaries of duty in making assignments and reporting information.

 Functioning procedures for soliciting, examining, accessing and making decisions

on customer loan applications.

 The documents required for each loan application and all the necessary papers
and records to be kept in the lender’s files like financial statements, pass book
details, security agreements, etc.

 Lines of authority and accountability for maintaining, monitoring, updating and

reviewing the institution’s credit files.

Loan policies vary significantly from one bank to another. It is completely

based on the complexity of the activities they are engaged in. The policy
elements of a private bank may slightly differ from the government bank.
Anyhow, a general loan policy incorporates specific basic lending tenets.