The banker while making advances/investments has to observe certain important principles. They are known as principles of good lending. The bankers have to follow these principles when appraising the proposal for advancing loans.
They may be classified as follows:
General principles
(i) Principle of diversification
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(ii) Principle of purpose
(iii) Principle of Security
(iv) Principle of National interest and suitability
Let us discuss these principles one by one.
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A. Basic Principles
These are considered as prime because the success of the bank depends upon these principles. They include the following:
(i) Safety:
A bank is a dealer in other people’s money. So, it cannot indulge in reckless risk. It should ensure the safety of funds while taking decision regarding landings and investments. One of the important risks involved in lending money is the credit risk i.e., the possibility of borrowers not repaying the money on due dates.
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It is therefore necessary for the banks to maintain expert staff to appraise every credit proposal received by it. Borrowers may default in payment, due to circumstances beyond his control.
For example, due to recessionary conditions in the economy, due to destruction of manufacturing activity by natural calamity. Hence banks have to appraise every credit proposal by taking into consideration market risk, individual borrower risk etc.
To avoid credit risk, the bank may call for acceptable securities, which will give full values on default. Likewise, the market risk can be avoided by preferring high-grade securities of shorter terms. While lending, a bank should grant advances only for short periods to creditworthy borrower and avoid granting advances for unproductive purposes.
The lending and investment policies of a bank are generally decided by the Board of Directors. In India the RBI also used to prescribe certain sound lending/investment policies to avoid credit or market risk.
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For example, as per RBI guidelines a bank should not lend more than 25 per cent of its owned funds i.e., in simple term paid up capital, free reserves and accumulated profits] to a single borrower. This prescription is known as Single Exposure Norm or Limit. International banks have such limit restricted to 15% of owned fund.
For Indian banks, this single exposure limit is being reduced to 20% from April, 2000 as per RBI policy guidelines. Safety of an advance or loan is determined on the basis of regular payment of interest and principal repayment as and when due.
(ii) Liquidity:
Liquidity means the ability of a bank to meet the demand of customers for his money. Simply to put it, the ability of bank to produce cash on demand. It is very importantly to be observed by every bank.
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Banks are able to obtain deposits from public on the basis of the confidence created by it to pay back the money when needed by depositors. It can do so only when it has invested certain portion of the deposit in such investments (like Government Securities) which can be sold quickly to convert them into cash.
This is the reason for which Statutory Liquidity Ratio (SLR) has been prescribed by RBI. A bank must have sufficient liquid assets to meet the demands of the depositors. The liquid assets should have the following characteristics.
(a) It should be convertible into cash quickly and easily.
(b) It should be convertible into cash without any risk of loss of value.
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The need of liquidity arises on account of the following reasons:
Banks accept deposits from the public. The public can demand their deposits back at any time. Inability to pay back deposits leads to failure of the banking system itself. Hence, a bank must maintain adequate liquidity.
Factors Determining Liquidity of Banks
The liquidity of banks depend upon the banking habits of the people, the volume and number of monetary transactions, nature of business conditions, the liquid reserve considerations, the structure of banking system and money market etc. In India banks have to keep reserves as legal requirements.
(i) Under Sec. 42 of the RBI Act, 1934 – the commercial banks have to keep a certain minimum reserve with RBI called CRR which is not less than 3 per cent and not exceeding 15 per cent of total Net Demand and Time Liabilities (NDTL).
(ii) Under Sec. 24 of the Banking Regulation Act, 1949 every commercial bank have to maintain liquid assets in the form of cash, gold, and gilt edged securities – SLR which is not less than 25 per cent and not more than 40 per cent of NDTL.
(iii) Profitability
SLR Calculation
For the basic understanding of students, the concept of Net Demand and Time Liabilities (NDTL) may be explained roughly as follows:
Bank XYZ Ltd. (As on a Reporting Friday) Demand Deposits: 100 crore
Time Deposits: 500 crore
Other outside Liability: 40 crore
Total outside liabilities: 640 crore
Plus:
Net position of payables (liabilities) over receivables (Assets) : 10 crore (only Excess of liabilities included) Total NDTL : 650 crore
If the bank is required to maintain SLR at 25 per cent, then 25 per cent of NDTL of Rs. 650 crore i.e., 162.50 crore is maintained in the form of investment in approved (mainly Govt) securities, cash and/or gold.
The basic objective of commercial banks is aiming at profit. That is, the bank carries on its entire functions to earn profit. Sound banking demands the use of bank funds in such a way so as to get the highest return/profit. It must earn sufficient profit to meet out its expenses and to pay adequate return to its shareholders.
But there is a trade-off between liquidity and profitability. For example the most liquid asset is not most profitable and vice versa. From the liquidity point of view, banks are expected to invest in high-grade securities of short-term. But they are not profitable as income from such investment is very low. Banks prefer long-term securities which yield higher returns. The objective of liquidity and profitability are contradictory.
The success of the bank depends upon its ability to balance between liquidity and profitability. Crothers has stressed the same by remarking as “the secret of successful banking is to distribute resources between the various forms of assets in such a way so as to get a sound balance between liquidity and profitability”.
Each depends on the others. No one or two can stand alone. If one leg of a stool is weaker or shorter, the stool of banking will be unstable. In effective banking, all the three elements are equal, interrelated and interdependent. They are all equally important.
B. General Principles
Besides the above basic principles, the banks have to follow certain other general principles in order to make a safe lending. They are:
(i) Principle of Diversity:
Another important principle of good lending is the diversification of advances. An element of risk is always present in every advance, however secure it might appear to be. In fact, the entire banking business is one of taking calculated risks and a successful banker is an expert in assessing such risks and avoiding or minimizing it in its operation.
The bank is keen on spreading the risks involved in lending, over a large number of borrowers, over a large number of industries and areas, and over different types of securities. For example, if it has advanced too large a proportion of its funds against only one type of security, it will run a big risk if that class of security steeply depreciates.
The bank has numerous branches spread over the country; it gets a wide assortment of securities against the advances. Slump does not normally affect all industries and business centres simultaneously. Unless there is a general recession in the economy. The principle of diversity is simply do not put all your eggs in a single baskets to avoid total loss.
(ii) Principle of Purpose or End use:
A banker must closely scrutinize the purpose for which the money is required, and ensure as far as he can, that the money borrowed for a particular purpose is applied by the borrower accordingly. The purpose should be productive so that the money not only remains safe but also provides a definite source of repayment.
The purpose should also be short-termed so that it ensures liquidity. Banks discourage advances for hoarding stocks or for speculative activities. There are obvious risks involved therein apart from the anti-social nature of such transactions.
Purpose has assumed a special significance in the present day concept of banking. This principle ensures end use of funds. In fact as per RBI guidelines, banks should ensure end use of funds in respect of large advances.
(iii) Principle of Security:
It has been a practice of banks not to lend as far as possible except against security. Security is considered as insurance or a cushion to fall back upon in case of an emergency. The bankers carefully scrutinize all the different aspects of an advance before granting it. Thus the security serves as a safety valve for an unexpected emergency. This is commonly accepted prudent lending policy.
(iv) Principle of National Interest and Suitability:
The consideration of national interest serves as a good principle of lending and investment. The Reserve Bank of India has issued directives prohibiting banks to allow certain particular type of advances.
For example, banks are not permitted to lend money to speculation in share or for real estate business. It is because that these activities are considered socially not desirable.
The law and order situation at the place where the borrower carries on his business may not be satisfactory. The advance may be on the security of manufactured goods of which proper valuation is not possible. There may be other reasons of a like nature for which it may not be suitable for the bank to grant the advance.
In the changing concept of banking, factors such as purpose of advance and national interest are assuming a greater importance than security, especially in advances to agriculture, small borrowers, and export oriented industries.
(v) Fee Based Services of Banks:
Banks are financial intermediaries. Apart from mobilizing deposits from savers and lending them to needy borrowers, banks help the savers and borrowers to transfer funds from one place to another in a secured way without physically moving the funds. Usually the following methods are adopted by banks for transfer of funds:
(i) Mail Transfer
(ii) Telegraphic Transfer
(iii) Demand Drafts
(iv) Pay orders
(v) Electronic Funds Transfer
Mail Transfer
Under Mail Transfer system, the remitter of funds is required to deposit the amount required to be remitted together with a challan detailing the particulars of remittance. This information will relate to the value of funds to be transferred, the bank account number and address of the receiver of funds, particulars of remitter and purpose of remittance etc.
Under this system it is necessary that both the parties to the remittance maintain bank accounts with the same bank, albeit with different branches / places.
This method of transfer of funds is called Mail Transfer since the advice of remittance is sent by mail / post by the remitting bank to the branch where the beneficiary has his account. On receipt of remittance information, the receiving branch will credit the account of the beneficiary. Thus it is an intra bank fund transfer.
The banks do not accept large cash (usually restricted to Rs. 20,000/-) for remittances. If the required remittance is large, bank will ask the remitter to draw a cheque on his account for the purpose of remitting funds. Banks also charge fees for this type of service.
This facility of fund transfer is provided usually to their own customers. Funds can be transferred only between branches of the same bank and not between one bank to another. It is also necessary that both the parties to the transfer maintain account with the same bank.
It is however a slow method for transfer of funds as advice regarding remittance is forwarded only through post. The paying branch will credit the account of the beneficiary only on receipt of the advice received from the remitting bank.
Telegraphic Transfer / Telex Transfer
The method followed for transfer of funds under Telegraphic Transfer / Telex Transfer (TT) is the same as in the case with Mail Transfer. However, the advice regarding remittance of funds will be sent by a telegram / telex by the remitting bank to the receiving bank.
As such the fund transfer will be quick and fast. Since the advice is sent by telegraphic/ telex message this mode of transfer of funds will be costlier than that of Mail Transfer. However,, the additional cost will be insignificant if we take into consideration the immediate availability of funds to the beneficiary. This method will be costly mainly for those who remit small amounts of money.
Demand Drafts
Drafts are basically Bills of Exchange. As in the case of bill of exchange, a draft is driven by one party on another party and made payable to the drawer himself or someone else. Demand Drafts are drafts drawn by a bank on its own branches at different places and made payable to third parties or purchaser of the draft.
Supposing you as a student desire to remit certain fees for taking up a competitive examination conducted by the Service Board, usually the Board asks all the candidates to remit the examination fees by demand drafts issued by banks.
In such a case, you may pay the requisite sum to a bank along with the prescribed challan detailing the name of the payee, purchaser or remitter, amount, place where it should be remitted, etc. The bank on receipt of the amount will issue a draft which has to be sent by the candidates to the Board along with the application.
For obtaining money or credit to the account, the payee (in the present case the Board) has to present the draft to the paying bank. Since these drafts are payable immediately on presentation by the payee, they are called demand drafts.
The drafts can be crossed “Account Payee “to restrict its transfer. Demand Drafts can be defined as cheques issued by a bank on its own branches or on other banks under corresponding arrangement.
Pay Order
Pay Orders are drafts issued by an office / branch of a bank on itself. In other words the issuing branch / office and paying branch / office are one and the same. Pay orders are issued by banks only against receipt of funds first. Suppose, a candidate desires to remit certain examination / admission fees to a particular educational authority.
In case both the candidate and the educational authority happen to maintain accounts with the same branch, then the candidate may remit the fees by obtaining a Pay Order instead of a demand draft. If the fees can be paid to any branches of the bank, then a demand draft can be obtained.
Thus, the main difference between pay order and a demand draft is that whereas a demand draft is issued by a bank on any of its branches, a pay order is issued on itself. In both the cases the bank will issue the instruments only after receipt of funds first.
Electronic Funds Transfer
Normally remittance or transfer of funds between banks gets originated by a paper instrument. For example, under Mail Transfer, the remitter has to fill up necessary challan and give it to the bank along with a cheque or cash for transfer of funds. Under Electronic Funds Transfer the transaction of funds transfer is initiated through an electronic equipment and systems or telephone or computer devices, etc.
In India, the Reserve Bank of India has introduced Electronic Funds Transfer ( EFT ) Scheme to assist banks in providing their customers fund transfer facility from one account to another either with the same bank or with different banks.
Under this system a customer desiring to remit certain amount to another place fills in the prescribed EFT application form together with the details like, beneficiary’s name, bank account number, name of the bank & branch, location of the branch, etc., and hands over the form and a cheque drawn on his account.
The remitting bank through one of its designated branches for this purpose transmits the details of transfer to the Reserve Bank of India.
The Reserve Bank at the transaction originating centres consolidates all such transfer advice and transmits information of transfer to its various centres for advising the concerned banks for providing the requisite credit to the beneficiaries.
Thus, it acts as an intermediary between the remitting bank and receiving bank and affects the transfer. The Reserve Bank allows up to Rs. 2.00 crore per transaction to be transferred in this way. Further it charges only Rs. 5.00 per transaction to banks.
The banks will charge separately fees on their customers for availing of this facility. However, fees charged by banks for transfer of funds under EFT system will be smaller as compared to remittance facilities under MT, TT and Demand Drafts.
This system of funds transfer is available with all the public sector banks and many of the private sector and State Cooperative banks. Fund transfer under EFT is possible from any branch to branch with the same bank or with other banks.
Other Fee Based Services
These services can be identified as:
Issue of Guarantees
Issue of guarantees on behalf of customers is one of the important revenue earning services provided by banks. In the course of commercial business the customers may be required to provide with a bank guarantee under different circumstances.
Guarantees basically serve the purpose of assuring that the work awarded to a person will be performed / executed in terms of a contract. If not, the guarantor will step in to pay any compensation stipulated under the contract. This service brings in sizeable income to the banks. The guarantee fees usually depend upon the value and period of guarantees as well as the customer-banker relationship.
Locker Facilities
Bankers make available Safety Locker Facilities to customers for keeping their valuables. In return, the bank levies half-yearly or annual charges which may depend upon the size of the lockers. The Lockers may be used to hold valuables like ornaments, jewellery, Share / Bond Certificates and other important documents. These items are held only at the risk of the customers. Banks will not be held liable if the customers misuse the locker facility.
Issue of Credit Cards
Banks issue their own as well as Cards of other reputed agencies under arrangement to customers. Banks collect charges for this facility from card holders depending upon the type of card, value limit, etc. The fees may be charged on annual basis with certain specified onetime entry fees also.
Under Portfolio Management Services, the banks accept large sums of money from wealthy customers for investment purposes with the permission of Reserve Bank of India. The guidelines governing PMS services are issued by Reserve Bank.
Banks are expected to maintain separate accounts for this purpose and they are not permitted to mix up these funds with their own funds. They cannot guarantee fixed income to customers under this scheme. Banks are basically expected to utilize the funds for investments and income generated out ot such activity will be credited to customers account.
Banks are, however, permitted to levy fees / charges for such services. Funds accepted under the Scheme should normally be for one year or more. Risk related to such investments will be that of the customers and not that of the bank.
Tax Advice
Most of the banks have their own Legal Departments. Although these Departments normally engage themselves to protect the interest of the institution from legal disputes, the Departments also have experts to provide legal counseling to customers. Such advice may pertain to personal taxation, capital gain tax and other tax issues.
Investment Guidance
These days a number of financial saving products are available for investors. Some of them are money market instruments like, Treasury Bills, Commercial Paper, Certificate of Deposits, etc. Some of them are Capital Market instruments like Shares, Bonds, and Government Securities with long term horizon.
Banks offer their expertise to customers in choosing the right type of investment depending upon the amount, duration, risk appetite, expected return, etc., of customers. Banks charge fees for providing such services. This type of service is different from that of PMS services mentioned above.
Under PMS, the banks accept large sum of money from a customer and utilize the funds for various investment in consultation with the customer and at his own risk. However, banks will provide investment advice and guidance for any customers and actual investment decision and employment of funds and maintenance of accounts there to will be done by the customers.
Agents for selling Financial Products
Under arrangement with other agencies engaged in Financial Services, banks sell their products like Credit / Debit Cards, ATM Services, etc., to customers. Although the banks may obtain a share of fees from other agencies, banks may also levy certain charges for these additional facilities.
Sale of Insurance Products
Recently, banks in India are permitted to sell insurance products to their customers under arrangement with Insurance Companies. These products may be life insurance policies, accident insurance policies, Pension Policies and other general insurance policies. Banks which have wide network of branches are expected to earn sizeable income / fees from these services.
Project Consultancy Services
Many first-time entrepreneurs need expert advice for crystallizing their investment ideas into workable projects. Unplanned schemes may run into cost escalation and delayed execution. Persons intending to put up small scale industries normally overlook many aspects of the project requirements like environment clearance, legal issues, etc. Banks will be in a better position to provide all round advice in such cases for certain fees.
Demat Accounts
Under SEBI guidelines, the issue and transfer of securities of many corporate are now required to be transacted in demat forms. The word ” Demat” is an abbreviation for Demate- rialized account.
Under Demat form, physical securities are converted into electronic form and held in accounts with banks and other institutions permitted to maintain this type of accounts.
This helps to avoid loss of securities, facilitate easy method of transfer and avoidance of large quantity of paper work and storage problem. Banks may usually levy a charge for maintaining such accounts although in many cases such service may be provided free of charge.
Letters of Credit
Banks issue Letters of Credits on behalf of their customers particularly in international trade. The issue of Letter of Credit may be a non-fund based service if banks are not providing their own funds to honour the bills drawn under letter of credit. Banks charge fees for issue of letters of credit which may depend upon the value of credit, tenor of credit and customer relationship.
Custodial Services
Apart from offering Safety Locker Facility, banks also provide custodial services for holding valuable financial instruments, important legal deeds and documents of customers against payment of periodic fees.
It should be remembered that under Locker Facility the banks make available Lockers on rental basis for safe keeping of valuables at customer risk.
However, under custodial services, the banks accept valuable documents, etc., of customers for safe custody, transfer, maintaining proper accounts relating to it and bank is liable for any wrong doing.
Presently Indian Corporate is permitted to raise equity funds from overseas market through issue of Global Depository Receipts (GDRs). The equity share issued against GDR entitlements are held with a bank in India under Custodial Accounts.
In this case the bank acting as a Custodian will maintain all records relating to the shares held and transferred under GDR mechanism and the bank will be earning certain fees from the company for this purpose.
Arranging Foreign Currency Loans from Overseas Market
Presently Government permits Indian Corporates to raise foreign currency loans from overseas market under certain conditions. Since they may not be well conversant with overseas market and the risk associated with it, the corporate take the assistance of banks for raising the loans at minimum cost.
Here the banks will not be providing their own funds but only help the corporate to raise cheap and reliable funds. The banks collect fees like management fees, etc., for such services. They may also arrange loan syndication against specific fees.
Charges in such cases will relate to the total fund raised, the duration of loan, management of loan accounts and other services expected of the bank under arrangement with the customers.
Other Fee Based Services
Innovation is one of the catch words in banking services today. Banks tend to innovate new types of services to suit the personal requirements of various customers as well as that of corporate-clients. As such these services will be different from banks to banks. In the established overseas markets, banks may also provide the following specialized services to corporate clients:
Factoring Services;
Forfeiting Services;
Bankers Acceptances, etc.
In India Factoring and Forfeiting services are provided by specialized agencies and not by banks. Similarly Bankers Acceptances are not popular in the Indian industry. Few years back banks were trying to popularize “Gift Cheque “scheme. However, it did not turn out to be a successful scheme.
Under Gift Cheque facility, a person intending to make a present to another person on occasions like wedding, birthday, etc., can buy a gift cheque from a bank of the required value and present it instead of making the present in cash or in kind.
Factors are basically institutions financing the receivables of corporate on recourse or non-recourse basis. In other words, the accounts receivables are sold outright to factors who arrange to collect the receivables directly from debtors.
It is beneficial to the corporate since they are able to realize funds on the bills immediately from the factor. The factor deducts commission or other charges plus interest component from the value of bills before making payment to customers.
Forfeiting is another method of purchasing the receivables of customers on non-recourse basis. However, Forfeiting is more common in international trade while Factoring is a common practice adopted in domestic trade.
Under Forfeiting the financing institution purchases long-term bills/ instruments on revolving basis up to certain maximum value and period unlike in the case of Factoring where financing is done for a short term. Since Forfeiting is always done under non-recourse basis, the discounted value is higher as compared to the discount under Factoring.
Bankers’ Acceptances refer to bills which have been accepted by banks. This acceptance enhances the safety aspect of the bill and becomes a good instrument for value to discount houses. Further bankers acceptances strike a better realization with lower discount.
Many of the services mentioned above like EFT Scheme, PMS Service, Investment Guidance, Issue of Letters of Credit, Demat Accounts, Custodial Services, Bankers Acceptances, Factoring and Forfeiting Services, Sale of Insurance Products, Issue of Credit / Debit Cards, ATM Services, Arrangement of Funds from Overseas Markets are being offered by banks recently in India.
The financial statements of a Banking company consists of 16 schedules of which the schedules 1 to 12 are for ‘Balance sheet’ items and the schedules 13 to 16 are for “Profit and Loss Account”, i.e., for Revenue items.
Among the schedules of Balance sheet, schedules 1 to 5 gives liabilities and the schedules 6 to 11 reveal about Assets. The schedule 12 gives contingent liabilities. Let us see the contents of these schedules one by one.
Bills for Collection:
Bills and other items in the course of collection and not adjusted will be shown against this item in the summary version only. No separate schedule is proposed.
The liabilities side of the balance sheet of a bank explains how the bank has mobilized its resources. It shows the bank’s indebtedness to its shareholders and to the public. It also shows the Reserves and provisions created out of past profits and the current year’s profit, if any.
The assets side reveals how the bank has invested its resources. From the balance sheet it can be seen that the asset side of the balance sheet is arranged in the order of liquidity, starting with cash the most liquid ones and ending with fixed assets and other assets which are least liquid.
On the liabilities side items are arranged in the order of descending urgency. The most urgent liability is shown in the last and capital which is paid back only in the event of winding up is shown first.