ADVANCING OF LOANS:

The second most primary function of a commercial

bank is to ‘Lend’.

In fact lending and accepting deposit are bread and

butter of a commercial banks.

Loans are given for:

o consumption,

o trade and commerce,

o agriculture,

o small scale industries,

o industrial loans,

o export or imports,

o vehicle, transport,

o housing and

o you name, and bank will tailor make the scheme to

suit the class of borrowers.
 Loans may be fund based or non-fund based
(wherein bank guarantee or LC is issued).

Loan may be fixed duration- term loans.

In this case a fixed amount is given.

This is repayable in monthly installments along

with interest. – called EMI (equated monthly
installments)

Out of EMI’s some portion goes towards the

principal and some portion goes towards the
interest.

These loans are given to acquire some assets like,

machinery, land and buildings, car, house etc.

The assets purchased out of bank finance are taken

as security.

Loans may be in the form of running account -

cash credit or overdraft.

Cash credit and overdraft are given to finance

“working capital needs” of a borrower.

“Working capital needs” means funds required to

meet day to day working of the borrower.
Like: buying raw materials, electricity bills,
telephone bills, wages and salaries etc.

“Working capital needs” of a borrower is

fluctuating and is not fixed unlike buying a
machinery, house etc.

Therefore to meet the needs of working capital (day

to day requirement) amount given by a bank is in
the form of running account.

The bank fixes the limit of the borrower.

The borrower can withdraw the amount as per his

requirements mainly for purchasing of goods,
payment of expenses and sale proceeds is deposited
by him.

The bank charges interest on the balance drawn by

the borrower and not on the limit fixed.

This way the borrower will be paying interest for

the amount withdrawn and for the period it is
withdrawn.
Bills discounting/ cheque discounting

A trader receives bill of exchange or cheque in settlement of his

claim from the debtor.

The banker discounts or purchases the bills or cheques of their

customers and provide him with funds which can be used by the
borrower for meeting his working capital requirements.

Example: ‘A’ a trader has sold goods to a trader ‘B’ at Mumbai

for Rs 1 lac.

‘B’ has given a cheque to ‘A’ for Rs 1 lac for settlement of his
dues. The cheque is drawn at Mumbai.

If ‘A’ deposits the same in his account it will take about 10 to 15

days for the cheque to be cleared.

If ‘A’ is in urgent need of funds he can request his banker to

purchase the cheque.

The bank depending on the nature of dealing of ‘A’ will

purchase the cheque and after deducting bank’s charges known
as discount charges, give credit to ‘A’.

Bank will send the cheque to Mumbai for collection and after it
is realized, clears its entry.

If the cheque is returned, bank will recover from ‘A’.

This way the trader gets credit against their

outstandings.
Loans advanced by the banks are classified as unsecured
and secured or partly secured.

If the banks have not taken any security then it is called

unsecured (clean loan).

Examples of unsecured loans are:

o Personal loans

o Educational loans etc

In the case of unsecured loans the banker relies on the personal

credit worthiness of the borrower and take one or more
guarantor to ensure safety of the advance.

Secured loans are those loans against which the banker holds
some security.

Bankers generally do not finance the full amount of the asset to

be purchased but asks the borrower to bring a margin which
varies from 10 to 15% depending on the type of security and the
credit worthiness of the borrower.

The purpose of taking margin is to cover the fall in the value of

security and also the increase in the amount of outstanding of
the borrower on account of interest, if the borrower does not pay
any amount.
Examples of such loans are:

Purpose Security

Car/ vehicle loans car/ vehicle

Housing loans House

Machinery loans Machinery

T.V / fridge loan T.V/ fridge

Inventory Inventory

Partly secured loans are those where the value of security does
not fully cover the amount of loan taken.

Non funds based advances

Bank Guarantee (BG).

In the case of Bank Guarantee the bank undertakes

to pay the stated amount to the beneficiary of bank
guarantee in case of default in meeting the obligation.
Example: Suppose ‘A’ wants to get a machine
manufactured from ‘B’ for Rs 10 lac.

They are not regularly dealing with each other as

machines are not bought everyday.

The machine is suitable only for ‘A’ and may not be

of any use to any body else.

If ‘B’ asks ‘A’ to pay the cost of machine of Rs 10 lac

before ‘B’ starts manufacturing the machine.

‘A’ may not give because of fear if ‘B’ does not

manufacture or delay he will lose the money and have
to litigate the matter for recovery.

On the other hand if ‘B’ starts manufacturing and later

on ‘A does not take delivery and does not pay, ‘B’ will
suffer a great loss.

To mitigate the hardship ‘B’ asks ‘A’ to arrange for a

bank guarantee in his favour for Rs 10 lacs.

In the Bank guarantee the bank will undertake to make

payment to ‘B’ if he delivers the machine to ‘A’

In Bank Guarantee document the conditions and date

of delivery etc will be clearly written.

Bank will charge his commission for issuing bank

guarantee.
Bank is not parting with the funds when they issue
bank guarantee.

But bank has to part with the funds if ‘A’ does not pay
when the machine is delivered.

Banks issue Bank guarantee to their credit worthy

borrowers and after taking suitable security.

Letter of Credit (L/C)

M/s ABC Ltd. an exporter of shirts to USA receives

and order from M/s XYZ from USA.

In the normal course they have two options:

One is to ask M/s XYZ to send the money in advance

so that the shirt may be sent.

This may not be accepted by the importer i.e. M/s

XYZ as if M/s ABC does not send the shirts, they will
suffer. There is risk on the part of importer.

Second option is to send the shirts and wait for the

payment.

The importer M/s XYZ may delay or not send the

payment or may even reject the goods leading to
litigation in USA.
The risk is on the part of exporter.

To mitigate the problem the exporter will request the

importer to send a letter of credit from a reputed bank
who will guarantee payment if the export is made and
all the conditions governing the export is complied
with.

This way the bank is undertaking to make payment.

Bank is substituting the credit of borrower with his

own credit.

This way neither the exporter will suffer due to lack of

clarity on the credit worthiness of the importer nor the
importer will suffer as the payment will be made only
after the export has been done and all the conditions
are complied with.

This is called non- fund based facility.

As when the export documents containing the bills of

lading, invoice and other inspection documents and
also if it is within the time limit of the letter of credit.

The bank will ask the importer to make payment and

if he refuses to make payment bank is obliged to make
payment and recover from the importer.
At this point of time the bank will part with the funds
and not when the letter of credit is issued.

These are the accommodations where the bank do

not part with the funds when they issue them but
may have to part with the funds if there is default.

In such cases bank do not charge interest when

they issue but charge only commission for
issuing.

If the payment is not made then the liability is

crystallized and then the bank will charge interest
on the amount paid by them.