Unit 3: Basics of bank lending

Bank lending is the deployment of deposited funds as interest-bearing credit, the single largest asset on a commercial bank's balance sheet and its principal source of income. Because the money lent belongs to depositors, every lending decision is a trust exercise constrained by regulation (in India, the RBI's directions under the Banking Regulation Act, 1949).

• Core tension: Reconciling profitability (higher yield on riskier loans) with safety (protecting depositor funds) and liquidity (ability to meet withdrawals).
• Fiduciary basis: A bank is a trustee of public money; prudence outranks aggressive growth.
• Intermediation margin: Profit arises from the spread between the lending rate and the cost of funds, net of operating cost and provisioning for defaults.
• Regulatory frame: Lending is governed by RBI exposure norms, priority-sector targets, income-recognition and asset-classification (IRAC) rules, and Basel capital requirements.

II. Principles of Lending

Sound guidelines that constrain which loans a bank should make.

A. Safety

The borrower must be able and willing to repay.

• Capacity and character: Appraised through the "Five Cs" — Character, Capacity, Capital, Collateral, Conditions.
• Primary vs secondary source: Repayment flows first from business cash flow (primary), with security (secondary) as fallback only.

B. Liquidity

Advances should be convertible to cash on schedule.

• Self-liquidating preference: Short-term working-capital loans that unwind as inventory sells are preferred over locked-in long-term exposures.
• Maturity matching: Lending tenor should align with the deposit profile to avoid asset-liability mismatch.

C. Profitability

The loan must earn an adequate risk-adjusted return.

• Risk-based pricing: Interest = cost of funds + operating cost + risk premium + margin.

D. Diversification and Purpose

Risk is spread and end-use controlled.

• Diversification: Avoid concentration in one borrower, sector or geography; honoured via RBI's single/group exposure ceilings.
• Purpose: Loans for productive, legal uses; speculative end-use is screened out.

III. Loan Policy

The board-approved document that codifies how a bank lends.

A. Purpose and Principle

It converts the principles above into enforceable internal rules so that lending is consistent, not discretionary.

• Delegation of authority: Sanctioning powers graded by amount and tier (branch → regional → head office → board).
• Scope: Defines target markets, acceptable products, and prohibited exposures.

B. Contents

• Exposure limits: Caps per borrower, group, industry and unsecured category.
• Pricing and margin norms: Benchmark rate (e.g., repo-linked external benchmark), spread, and required borrower margin/down-payment.
• Collateral and documentation standards: Acceptable security, valuation frequency, and legal-charge creation.
• Review and NPA norms: Periodic renewal cycle and recovery escalation triggers.

IV. Basics of Loan Appraisal

The structured investigation of a proposal before sanction.

A. Definition and Objective

Appraisal tests whether a request is technically feasible, financially viable and bankable.

• Six appraisal dimensions: Technical, commercial (market), financial, economic, managerial and environmental feasibility.

B. Credit Investigation

• KYC and standing: Identity verification plus credit bureau checks (CIBIL/CRIF score).
• Financial-statement analysis: Ratios such as current ratio (≥ 1.33 benchmark for working capital), debt-equity, DSCR.

DSCR = (Net Profit + Depreciation + Interest) / (Interest + Principal instalment)

A DSCR ≥ 1.5–2 signals comfortable debt-servicing capacity.

C. Working-Capital Assessment

• Operating cycle method: Gauges fund need from the cash-to-cash cycle length.
• MPBF (Tandon) approach: Maximum Permissible Bank Finance = 0.75 × (Current Assets − Current Liabilities), ensuring the borrower funds a quarter of the working-capital gap.

V. Credit Decision-Making

Converting appraisal findings into a sanction, decline or modification.

A. The Decision Framework

It balances expected return against assessed risk within policy limits.

• Credit risk rating: An internal scorecard grades the borrower (e.g., AAA to D), driving pricing and the provisioning expectation.
• Four-eyes principle: The appraiser and the sanctioning authority are separate persons to curb bias and fraud.

B. Sanction Terms

• Covenants: Conditions precedent (security creation) and ongoing covenants (minimum ratios, periodic statements).
• Committee route: Large exposures cleared by a credit committee rather than a single officer, with recorded reasoning.

VI. Credit Review

The ongoing monitoring of a loan after disbursement.

A. Purpose

Early detection of deterioration so remedial action precedes default.

• Annual renewal: Limits are reassessed each year against fresh financials and conduct.
• Loan Review Mechanism (LRM): An independent post-sanction audit of a sample of large accounts to test underwriting quality.

B. Monitoring Tools

• Account conduct: Watching for cheque returns, overdrawing, and stagnant turnover in the operating account.
• Early Warning Signals (EWS): Delayed statements, declining stock, diversion of funds — triggering a "Special Mention Account" tag.
  • SMA classification: SMA-0 (overdue up to 30 days), SMA-1 (31–60 days), SMA-2 (61–90 days), after which the account turns NPA.

VII. Types of Advances

The forms in which credit is extended.

A. Fund-Based Advances

The bank parts with cash immediately.

1. Term loan: Lump-sum for fixed assets, repaid in instalments over a defined tenor.
2. Cash credit / Overdraft: A running limit against security of stock/receivables (CC) or in a current account (OD); interest only on the drawn balance.
   • Bills purchased/discounted: Advance against trade bills, self-liquidating on the bill's maturity.
   • Demand loan: Repayable on demand, often against financial collateral.

B. Non-Fund-Based Advances

A contingent commitment; no immediate outflow but exposure if invoked.

1. Letter of Credit (LC): Bank guarantees payment to a seller on documentary compliance.
2. Bank Guarantee (BG): Bank undertakes to pay a beneficiary if the customer defaults on a performance or financial obligation.

C. Secured vs Unsecured

• Secured: Backed by tangible/financial collateral, with a registered charge (hypothecation, pledge, mortgage).
• Unsecured: Clean advances relying on creditworthiness alone; capped tightly under loan policy.

VIII. Non-Performing Assets

Advances that have stopped generating income for the bank.

A. Definition (IRAC Norms)

A loan is an NPA when interest or principal remains overdue for more than 90 days.

• Classification stages:
  • Standard: Performing, no default.
  • Sub-standard: NPA for up to 12 months.
  • Doubtful: Sub-standard for a further period beyond 12 months.
  • Loss: Identified as uncollectible, though not yet written off.

B. Provisioning and Impact

Banks must set aside capital against NPAs, eroding profit.

• Provisioning ladder: ~15% on secured sub-standard, rising to 100% on loss assets.
• Income reversal: Interest already booked on an account turning NPA must be reversed — it was never real income.
• Twin impact: NPAs cut earnings (lost interest + provisions) and strain capital adequacy.

IX. Management of Non-Performing Assets

The toolkit for preventing, resolving and recovering stressed loans.

A. Preventive Management

Stopping standard assets from slipping.

• EWS and SMA tracking: Act at the SMA stage, before the 90-day threshold.
• Restructuring: Revising terms (longer tenor, moratorium) for viable but stressed units.

B. Resolution and Recovery Channels

1. Negotiated routes: Compromise/one-time settlement (OTS) and Lok Adalats for smaller dues.
2. Legal and statutory routes:
   • SARFAESI Act, 2002: Lets secured creditors seize and sell collateral without court intervention.
   • DRT: Debt Recovery Tribunals for claims above the prescribed threshold.
   • IBC, 2016: Time-bound insolvency resolution through the NCLT, with resolution or liquidation as outcomes.

C. Transfer and Write-off

• ARCs: Asset Reconstruction Companies buy NPAs at a discount, cleaning the bank's books.
• Write-off: Removing a fully provided loss asset from the books while retaining the right to recover.

X. Unified Lending Interface

A public digital infrastructure to make credit faster and cheaper.

A. Purpose and Principle

Launched by the RBI (pilot 2023), the ULI is an open, standardised platform that pulls a borrower's authenticated data from scattered sources through consented APIs, so lenders can underwrite in minutes rather than weeks.

• Consent-based access: Data flows only with the borrower's permission, under the Account Aggregator framework.
• "Plug-and-play" APIs: A common technical standard removes the need for each bank to build bespoke integrations.

B. Mechanism and Significance

• Data aggregation: Links land records, GST data, Aadhaar e-KYC, bank statements and dairy/satellite data for farmers and MSMEs.
• Frictionless flow: Positioned as a "new trinity" with JAM and UPI — UPI moved payments, ULI aims to move credit.
• Financial inclusion: Enables small-ticket and rural lending by replacing collateral-heavy appraisal with verifiable digital data, shrinking turnaround time and cost.