Unit 3: Basics of bank lending - Subjective Questions

The principles of lending are the fundamental guidelines that banks follow to ensure the safety and profitability of their loans. The key principles are:

• Safety: The borrower must be able to repay the loan along with interest. The bank must ensure that funds lent are recovered without loss.
• Liquidity: Banks lend from deposits that are repayable on demand, so loans should be convertible into cash without much loss. Advances should not be locked up for long periods.
• Profitability: Banks must earn adequate return (interest) to cover costs of funds, operational expenses, and provide profit to shareholders.
• Purpose: The purpose of the loan should be productive and legitimate. Loans for speculative or unproductive purposes are avoided.
• Security: Adequate and realizable security reduces the risk of loss in case of default.
• Diversification/Spread: Banks spread advances across sectors, industries, and borrowers to reduce concentration risk.
• National Interest: Lending should align with national economic priorities such as priority sector lending.

By balancing safety, liquidity, and profitability, a bank maintains financial stability while serving the credit needs of the economy.

A loan policy is a formal written framework formulated by a bank's board of directors that governs its lending activities. It provides direction and standards for credit officers to ensure consistency, control risk, and comply with regulations.

Main components:

• Lending authority: Defines the delegation of sanctioning powers at various levels.
• Credit limits: Exposure limits for individual borrowers, groups, industries, and sectors.
• Types of loans offered: Specifies permissible categories of advances.
• Pricing of loans: Guidelines on interest rates, spreads, and fees.
• Collateral requirements: Norms for acceptable security and margins.
• Documentation standards: Required legal and financial documents.
• Loan review mechanism: Procedures for monitoring and periodic review.
• Regulatory compliance: Adherence to RBI guidelines and statutory norms.

Importance:

• Ensures uniformity and consistency in credit decisions.
• Helps in risk management and control of bad loans.
• Provides a benchmark for performance evaluation.
• Ensures regulatory compliance and sound governance.
• Guides officers in objective decision-making.

Loan appraisal is the systematic evaluation of a loan proposal to assess the creditworthiness of the borrower and the viability of the proposal. The process typically involves assessing the following dimensions, often summarized as the 6 C's of credit (Character, Capacity, Capital, Collateral, Conditions, Common sense):

Key steps/aspects:

• Managerial appraisal: Evaluating the competence, integrity, and track record of the management/borrower.
• Technical appraisal: Assessing the technical feasibility of the project — technology, location, raw materials, and capacity.
• Financial appraisal: Analyzing financial statements, ratios, projected cash flows, and profitability. Tools like Debt-Service Coverage Ratio (DSCR) and Break-Even Analysis are used.
• Economic/Commercial appraisal: Studying market demand, competition, and marketing arrangements.
• Environmental appraisal: Checking compliance with environmental laws.

Financial viability indicators:

• (should ideally exceed 1.5–2).
• Positive Net Present Value (NPV) and acceptable Internal Rate of Return (IRR).

The appraisal ensures that the loan is safe, productive, and recoverable, forming the basis for the credit decision.

The 5 C's of credit are a framework used by banks to evaluate the creditworthiness of a borrower during credit decision-making:

• Character: The borrower's integrity, reputation, honesty, and willingness to repay. Assessed through credit history and references.
• Capacity: The borrower's ability to repay the loan from income or business cash flows. Measured using income statements, cash flow projections, and ratios like DSCR.
• Capital: The borrower's own financial stake (net worth) in the business. A higher capital contribution signals commitment and reduces lender risk.
• Collateral: Assets pledged as security against the loan. Provides a secondary source of repayment in case of default.
• Conditions: The economic and industry conditions, purpose of the loan, and external factors affecting repayment ability.

Some frameworks add a 6th C — Common sense/Control — relating to regulatory compliance and prudent judgment. Together, the 5 C's provide a holistic view of risk and guide the lending decision.

Credit review or Loan Review Mechanism (LRM) is a systematic process of evaluating the quality of a bank's loan portfolio on an ongoing basis, independent of the loan sanctioning function.

Objectives:

• To identify early warning signals of weakness and potential default.
• To ensure compliance with the bank's loan policy and regulatory guidelines.
• To assess the adequacy of documentation and security.
• To evaluate the correctness of asset classification and provisioning.
• To monitor portfolio quality and concentration risk.
• To provide feedback to improve credit appraisal standards.

Features:

• Conducted by an independent review team not involved in sanctioning.
• Covers a representative sample of large and high-risk accounts.
• Involves periodic review at defined intervals.
• Reports findings to senior management for corrective action.

An effective LRM helps minimize NPAs, improves credit discipline, and strengthens the overall health of the loan portfolio.

Commercial banks provide various types of advances to meet different credit needs. The major types are:

1. Based on form:

• Loans: A fixed amount sanctioned and disbursed as a lump sum, repayable in installments. Interest is charged on the entire amount.
• Cash Credit: A running account against hypothecation/pledge of stock, with a sanctioned limit. Interest is charged only on the amount utilized.
• Overdraft (OD): Facility allowing a current account holder to withdraw beyond the credit balance up to a limit.
• Bills Purchased and Discounted: Bank provides finance against bills of exchange before maturity.

2. Based on security:

• Secured advances: Backed by tangible security (mortgage, pledge, hypothecation).
• Unsecured/Clean advances: Granted on personal creditworthiness without collateral.

3. Based on tenure:

• Short-term advances: For working capital needs (up to 1 year).
• Medium-term advances: 1 to 5 years, for machinery/equipment.
• Long-term advances: Over 5 years, for projects and infrastructure.

4. Based on purpose:

• Working capital finance, term loans, retail loans (housing, vehicle, education), priority sector loans, etc.

These advances help banks diversify their portfolio and serve varied customer requirements.

Both cash credit and overdraft are forms of running finance, but they differ in several respects:

In essence, cash credit is a structured working capital arrangement tied to stock, whereas overdraft is a flexible facility to meet temporary liquidity needs.

A Non-Performing Asset (NPA) is a loan or advance for which the principal or interest payment remains overdue for a period of more than 90 days. An NPA ceases to generate income for the bank.

Norms for classification (as per RBI):

• Term loan: Interest and/or installment of principal remains overdue for more than 90 days.
• Cash Credit/Overdraft: The account remains out of order for more than 90 days (outstanding balance continuously exceeds the sanctioned limit/drawing power, or no credits for 90 days).
• Bills purchased/discounted: The bill remains overdue for more than 90 days.
• Agricultural loans: Overdue for two crop seasons (short-duration crops) or one crop season (long-duration crops).

Categories of NPAs:

• Sub-standard assets: NPA for a period up to 12 months.
• Doubtful assets: Remained sub-standard for 12 months.
• Loss assets: Identified as uncollectible, where loss is identified but amount not fully written off.

Proper identification of NPAs is crucial for accurate provisioning and assessing the true financial health of a bank.

NPAs are classified into three categories based on the period they have remained non-performing and the extent of security/realizability. Each attracts a specific provisioning requirement:

1. Sub-standard Assets:

• An asset that has remained an NPA for a period less than or equal to 12 months.
• Provisioning: 15% of outstanding on secured portion; 25% on unsecured exposure.

2. Doubtful Assets:

• An asset that has remained in the sub-standard category for 12 months.
• Provisioning (secured portion):
  • Up to 1 year doubtful: 25%
  • 1 to 3 years: 40%
  • More than 3 years: 100%
• Unsecured portion: 100%.

3. Loss Assets:

• An asset identified as uncollectible by the bank/auditors/RBI, where little or no recovery is possible.
• Provisioning: 100% of the outstanding amount.

Standard Assets (performing) also require a general provision (e.g., 0.40% for most, higher for specific sectors). Provisioning ensures banks absorb potential losses and present a true financial position.

NPAs arise due to a combination of internal and external factors:

Internal (borrower-related) causes:

• Diversion of funds to unrelated activities or related entities.
• Mismanagement and poor business decisions.
• Project delays and cost overruns.
• Technological obsolescence and inefficient operations.
• Willful default by borrowers.

Bank-related causes:

• Poor credit appraisal and inadequate due diligence.
• Weak monitoring and follow-up of accounts.
• Inadequate collateral and documentation lapses.
• Pressure for lending targets leading to compromised standards.

External causes:

• Economic slowdown and recession reducing demand.
• Changes in government policy, regulations, or taxation.
• Natural calamities affecting agriculture and businesses.
• Market volatility, price fluctuations, and exchange rate risks.
• Delayed payments from government or large buyers.

Understanding these causes helps banks strengthen appraisal and monitoring to prevent fresh slippages into NPA.

Banks adopt several strategies for managing and recovering NPAs:

Preventive measures:

• Robust credit appraisal and due diligence.
• Effective loan review mechanism and early warning systems.
• Regular monitoring of accounts.

Recovery and resolution mechanisms:

• Lok Adalats: For speedy settlement of small loans.
• Debt Recovery Tribunals (DRTs): For recovery of dues above a threshold.
• SARFAESI Act, 2002: Enables banks to seize and sell secured assets without court intervention.
• Insolvency and Bankruptcy Code (IBC), 2016: Time-bound resolution of stressed assets through NCLT.
• Asset Reconstruction Companies (ARCs): Banks sell NPAs to ARCs for recovery.
• Corporate Debt Restructuring (CDR)/Restructuring: Rescheduling of repayment terms for viable units.
• One-Time Settlement (OTS)/Compromise settlement: Negotiated settlement with borrowers.
• Write-offs: Removing unrecoverable loans from books (with continued recovery efforts).

RBI frameworks:

• Prompt Corrective Action (PCA), stressed asset frameworks, and provisioning norms.

A combination of preventive and curative measures helps banks reduce NPAs and improve asset quality.

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002 empowers banks and financial institutions to recover their dues from defaulting borrowers without the intervention of courts.

Key provisions:

• Enforcement of security interest: Banks can take possession of secured assets of the defaulter and sell/lease them to recover dues.
• Securitisation: Allows conversion of loans into marketable securities.
• Asset Reconstruction: Permits setting up of Asset Reconstruction Companies (ARCs) to acquire and manage NPAs.
• Central Registry (CERSAI): Records security interests to prevent fraud.

Recovery process:

1. Account classified as NPA.
2. Bank issues a 60-day notice demanding repayment.
3. If borrower fails to pay, the bank can take possession, manage, or sell the secured asset.

Benefits:

• Provides a fast and effective recovery mechanism.
• Reduces dependence on lengthy court procedures.
• Acts as a deterrent against willful default.

The Act applies to secured loans above a specified amount and excludes agricultural land. It has significantly strengthened the recovery framework in India.

The Unified Lending Interface (ULI) is a technology platform launched by the Reserve Bank of India (RBI) to enable frictionless and seamless delivery of credit, especially to agricultural and MSME borrowers.

Concept:

• ULI provides a standardized, plug-and-play architecture that connects lenders with multiple data service providers through standardized APIs.
• It enables the digital flow of borrowers' financial and non-financial data (land records, KYC, credit history, GST data, etc.) with consent, reducing the time taken for credit appraisal.

Key features:

• Consent-based data sharing from various sources.
• Standardized APIs reducing complexity of multiple integrations.
• Enables faster credit assessment and disbursal.
• Reduces operational costs and documentation burden.

Significance:

• Enhances financial inclusion by reaching underserved segments.
• Reduces turnaround time for loan processing.
• Minimizes information asymmetry and improves credit decisions.
• Complements UPI (payments) and Account Aggregator framework — forming part of India's digital public infrastructure.

ULI is often described as part of the 'new trinity' (JAM–UPI–ULI) aimed at revolutionizing credit delivery in India.

Advances are classified based on whether they are backed by security:

Key point: As per the Banking Regulation Act, a secured loan is one made against security whose market value is not less than the loan amount at any time. Unsecured advances rely on the borrower's reputation and repayment capacity, hence attract higher scrutiny and pricing.

To secure advances, banks create a charge on the borrower's assets. The main modes are:

1. Mortgage:

• Transfer of interest in immovable property (land, building) to secure a loan.
• Governed by the Transfer of Property Act, 1882.
• Types include simple, equitable (by deposit of title deeds), and registered mortgage.

2. Pledge:

• Bailment of movable goods as security where possession is transferred to the lender (pledgee).
• Governed by the Indian Contract Act, 1872.
• Example: Gold loan where ornaments are kept with the bank.

3. Hypothecation:

• Charge on movable property (stock, vehicles) where possession remains with the borrower, but the asset is charged to the bank.
• Common in cash credit against inventory.
• Example: Vehicle loan, stock-based working capital.

4. Lien:

• The right of the creditor to retain possession of goods/securities belonging to the debtor until the debt is cleared.
• Can be particular lien (specific debt) or general lien (all dues).

Summary: Mortgage relates to immovable property; pledge and hypothecation relate to movables (differing in possession); lien is a right of retention. Choosing the right charge ensures effective security realization.

The credit decision-making process is a structured sequence of steps a bank follows from receiving a loan request to disbursal and monitoring:

1. Receipt of loan application: Borrower submits application with required documents and KYC.

2. Preliminary screening: Initial assessment of eligibility, purpose, and completeness of documents.

3. Credit appraisal: Detailed evaluation of:

• Borrower's character and track record (credit score/CIBIL).
• Financial analysis — statements, ratios, cash flows.
• Technical and commercial viability of the proposal.
• Security/collateral adequacy.

4. Risk assessment and rating: Assigning an internal credit risk rating to the borrower.

5. Sanction decision: Approval by the appropriate sanctioning authority as per delegated powers, deciding the amount, rate, tenure, and terms.

6. Documentation and execution: Signing of loan agreements, creation of charge/security.

7. Disbursement: Release of funds as per agreed terms.

8. Post-sanction monitoring: Ongoing follow-up, end-use verification, and periodic review to detect early warning signals.

This disciplined process ensures that credit decisions are objective, well-documented, and risk-controlled.

The Debt-Service Coverage Ratio (DSCR) measures a borrower's ability to service debt obligations from operating income. It is a key financial appraisal tool.

Formula:

Given data:

• Net Operating Income = ₹3,00,000
• Total Debt Service = ₹2,00,000

Calculation:

Interpretation:

• A DSCR of 1.5 means the project generates 1.5 times the income required to meet its debt obligations.
• A DSCR greater than 1 indicates the borrower can comfortably service the debt. Banks generally prefer a DSCR between 1.5 and 2 for term loans.
• Here, DSCR = 1.5 is acceptable, suggesting the project has adequate cushion to repay the loan, making it a viable lending proposition.

Thus, based on DSCR, the loan proposal appears financially sound.

Both DRT and IBC are legal mechanisms for recovery/resolution of bad loans, but they differ in scope and approach:

Key difference: DRT is primarily a recovery mechanism for creditors, while IBC is a comprehensive insolvency resolution framework aiming to revive viable businesses or liquidate unviable ones in a time-bound manner. IBC has shifted power to creditors and improved resolution outcomes.

Priority Sector Lending (PSL):
PSL refers to lending by banks to sectors identified by the RBI as important for the inclusive growth of the economy. These include:

• Agriculture
• Micro, Small and Medium Enterprises (MSMEs)
• Education
• Housing
• Export credit
• Social infrastructure and renewable energy
• Weaker sections

Banks are required to lend a prescribed percentage (generally 40% of Adjusted Net Bank Credit) to priority sectors. PSL promotes financial inclusion and supports national economic priorities.

Diversification principle:
Diversification means spreading advances across different:

• Sectors and industries
• Geographies
• Borrower types and sizes

Significance of diversification:

• Reduces concentration risk — avoids over-exposure to a single sector/borrower.
• Minimizes impact of a downturn in any one industry.
• Ensures a balanced and stable portfolio.
• Aligns with the principle of 'not putting all eggs in one basket'.

Together, PSL ensures the bank serves national interest, while diversification protects the bank from systemic and concentration risks, balancing social responsibility with prudent risk management.

Early Warning Signals (EWS) are indicators that suggest a loan account may be heading towards default or stress before it is actually classified as an NPA. Timely detection enables preventive action.

Common early warning signals:

Financial signals:

• Default or delay in payment of interest/installments.
• Frequent overdrawing beyond sanctioned limits.
• Decline in sales/profitability and deteriorating financial ratios.
• Return of cheques due to insufficient funds.
• Delay in submission of stock statements or financial data.

Operational/behavioural signals:

• Diversion of funds to unrelated purposes.
• Reduced turnover in the account.
• Non-cooperation by the borrower; avoiding bank officials.
• Frequent requests for ad hoc limits or restructuring.
• Labour problems, legal disputes, or management changes.

External signals:

• Adverse industry/market conditions.
• Negative news or legal action against the borrower.

Importance of monitoring:

• Enables timely corrective action (restructuring, follow-up, additional security).
• Helps prevent slippage into NPA category.
• Protects the bank's asset quality and profitability.
• Supports a strong credit monitoring and loan review mechanism.

Effective EWS monitoring is a cornerstone of proactive NPA management.