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Fundamentals of Loans & Advances

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Banks are financial institutions which ultimate aim is profit. As a profit oriented organization a bank invests its funds in many ways to earn income as well as to serve interests to the depositors. To do this bank faces the risk of default in repayment. Though the procedures of banks lending involves some degree of risk, by lending the banking industry promotes economic activities of a country.
It is known to us that Finance is the provision of fund from surplus economic units to deficit economic units. As a financial institution the basic function of a commercial bank is accepting deposits and giving loans. Commercial banks contribute to economic development by creating cash flow of fund, facilitates consumers and producers by giving loans, promoting trades, generating employment, encouraging entrepreneurship specially in SME and Agri sector.

To understand the key function of a commercial bank an overview of loans and advances is given here:

Advance or Credit- is the confidence of the lender on the ability and willingness of the borrower to repay the debt as per schedule of repayment.

Categories of Loans and Advances :

All types of credit facilities can be broadly classified into two groups-

A. Funded Credit,
B. Non funded Credit.

A. Funded Credit: Those credit facilities which involve direct outflow of Bank's fund.

a. Loans - which are repayable within a specific time period under a specific repayment schedule and withdrawal is not allowed after adjustment.

1. Demand Loan- to meat short term working capital;

2. Term Loan (Short, Medium and Long)-to meet fixed capital expenditure;

b. Cash Credit (CC)/ Overdraft (OD) - An arrangement where transactions may be made within certain limit and have an expiry date for full adjustment.

1. CC (Pledge)
2. CC (Hypothecation)

c. Bill Discounted and Purchased

1. Discount-Allowing advances by discounting usance bills.
2. Purchase- Financing against sight/demand bills.

B. Non Funded credit: Those credit facility which does not involve any direct outflow of Bank's fund.

a. Letters of Credit (LC)- is an instrument issued by a bank on behalf of the importer
promising to pay the exporter upon presentation of shipping documents in  compliance with the terms stipulated therein.

b. Bank Guarantee- Guarantee given to Bid Tenders or to perform Work Orders.

i) Performance Guarantee
ii) Bid Guarantee

All loans and advances will be grouped into four (4) categories for the purpose of
classification, namely-

(a) Continuous Loan
(b) Demand Loan
(c) Fixed Term Loan and
(d) Short-term Agricultural & Micro- Credit.

a) Continuous Loan: The loan accounts in which transactions may be made within certain limit and have an expiry date for full adjustment will be treated as Continuous Loan. Examples are: Cash Credit, Overdraft, etc.

b) Demand Loan: The loans that become repayable on demand by the bank will be treated as Demand Loan. If any contingent or any other liabilities are turned to forced loan (i.e. without any prior approval as regular loan) those too will be treated as Demand Loan. Such as: Forced Loan against Imported Merchandise, Payment against Document, Foreign Bill Purchased, and Inland Bill Purchased, etc.

c) Fixed Term Loan: The loans, which are repayable within a specific time period under a specific repayment schedule, will be treated as Fixed Term Loan.

d) Short-term Agricultural & Micro-Credit: Short-term Agricultural Credit will include the short-term credits as listed under the Annual Credit Programme issued by the Agricultural Credit and Financial Inclusion Department (ACFID) of Bangladesh Bank. Credits in the agricultural sector repayable within 12 (twelve) months will also be included herein. Shortterm Micro-Credit will include any micro-credits not exceeding an amount determined by the ACFID of Bangladesh Bank from time to time and repayable within 12 (twelve) months, be those termed in any names such as Non-agricultural credit, Self-reliant Credit, Weaver's Credit or Bank's individual project credit.

Other different categories of loans:

i) Transport Loan
ii) Consumer Loan
iii) House Finance
iv) Auto Loan
v) SME Loan
vi) Agri Loan
vii) Micro-Credit
viii) Consortium Loan
ix) Syndicated Loan
x) Lease financing
xi) Hire purchase
xii) Import finance (LTR, LIM)
xiii) Export finance (Packing credit, back to back LC)

Principles of Lending- Banks are required to follow certain basic principles of lending.

a. Safety- security and repaying capacity,
b. Liquidity- ability of an asset to convert in to cash without loss,
c. Profitability- brings adequate return for the bank,
d. Purpose- should be productive,
e. Spread- Diversification of advance.

Borrower Selection: To reduce the risk of default in payment, bankers must consider some specific criteria in case of borrower selection.

The 5 Cs of Credit -

- Character: Borrower's Integrity, Honesty and Intention to repay the loan money,
- Capacity: Borrower's business ability, particularly profit making report,
- Collateral: Borrower’s ability to produce additional securities,
- Conditions: It is general business condition, and
- Capital: Financial strength to cover a business risk.

The 5 Ps of Credit -
- Person ,
- Purpose,
- Product,
- Place, and
- Profit.

The 5 Ms of Credit -
- Man,
- Money,
- Materials,
- Market, and
- Management.

The 5 Rs of Credit -
- Responsibility,
- Reliability,
- Respectability,
- Resources, and
- Returns.

Loan Classification: Loan Classification is the act of grouping of loans and advances according to their status based on given criteria.

Objectives of loan classification:

i) Find out net-worth of a bank,
ii) Help for assessing financial soundness of a bank,
iii) Help for determining required provision and the amount of interest suspense,
iv) Put the bank on sound footing in order to develop sound banking practice in
Bangladesh.

As per loan classification criteria loans fall under the following status.

a) Unclassified;
i) Standard,
ii) SMA (Special Mention Account),
b) Classified;
i) SS (Sub-standard),
ii) DF (Doubt Full),
iii) BL (Bad & Loss).

Basis for Loan Classification:

a) Objective Criteria: The loan status would be Past Due/Over Due, SMA, SS, DF, BL on the basis of overdue period.
b) Qualitative Judgment: If any uncertainty or doubt arises in respect of recovery of any Continuous Loan, Demand Loan or Fixed Term Loan, the same will have to be classified on the basis of qualitative judgment be it classifiable or not on the basis of objective criteria. If any situational changes occur in the stipulations in terms of which the loan was extended or if the capital of the borrower is impaired due to adverse conditions or if the value of the collateral decreases or if the recovery of the loan becomes uncertain due to any other unfavorable situation, the loan will have to be classified on the basis of qualitative judgment .

Security and Creating charges on securities

Security: Security means things deposited as a guarantee of a loan or undertaking, to be forfeited in case of default. Security works as an insurance against an emergency.

Types of security:

A. Tangible securities-
I. Primary Security; and
II. Collateral Security.

B. Intangible securities (Personal securities)-
I. Personal guarantee of borrower’s (Borrower’s Liability)
II. Personal guarantee of third party.

Primary Security: Primary security is the principal or direct security against which loan is sanctioned.

Collateral Security: A Collateral Security is an additional, secondary or subsidiary security provided by the borrower.

Attributes of a good security:

 Ready Marketability;
 Easy ascertainment of value;
 Stability of value;
 Storability;
 Clear & undisputed title;
 Easy transfer of title;
 Absence of contingent liability.

Safe custody of security documents: Custodial duties is the important function of Credit Department/Credit Administration Department (CAD) who ensure that proper security documentation is held under strict control, preferably in locked fireproof storage in a systematic manner.

Creation of Charges on Securities: Creating a charge means making it available as a cover for an advance. The method of charging should be legal, perfect and complete.

Method of creating charges:
1. Mortgage;
2. Pledge;
3. Hypothecation;
4. Lien;
5. Assignment
6. Set-off.

Mortgage: As per Section 58A of Transfer of Property Act, 1882, Mortgage is the transfer of an interest in specific immovable property for the purpose of securing the payment of money advances or to be advanced by the way of loan, an existing or future debt or the performance or an engagement which may give rise to a pecuniary liability.

The instrument by which the transfer is effected is called a 'Mortgage Deed'.

Different forms of mortgage:

i. Registered Mortgage;
ii. Equitable Mortgage (Deposit of Title Deed);
iii. English Mortgage;
iv. Mortgage by conditional sale;
v. Usufractuary;
vi. Anomalous Mortgage.

Note: Now registered mortgage is only acceptable way of mortgage for Banks.
Pledge: Pledge is the Bailment of goods as security for payment of a debt or performance of a promise. (Sec-172 of the Contract Act)

Bailment is the delivery of goods by one person to another for some purpose, under a contract that the goods shall, when the purpose is accomplished, be returned or otherwise disposed of, according to the direction of the persons delivering them. (Sec-148 of the Contract Act)

Features:

1. Moveable property;
2. Delivery by the borrower to lender;
3. Ownership with borrower;
4. Possession with the lender;
5. Preserved properly in the bank's godown at the expense of the borrower.

Hypothecation: Hypothecation is a charge against property for an amount of debt where neither ownership nor possession is passed to the creditor. Though the borrower is an actual physical possession but the constructive possession remains with the Bank as per deed of hypothecation.

Features:
1. Moveable property;
2. Ownership and possession remains with borrower;
3. The lender has no effective control over the securities;
4. Possession of the hypothecated goods transferred to the bank when called upon to do so.

Lien: Lien implies right of the creditor in possession of goods or securities belonging to a debtor to retain them until a debt due from the latter are paid.
Lien gives the lender only a right to retain the possession of securities and not the power to sell unless such a right is expressly conferred by statute or by custom or usage.

Assignment: An assignment means a transfer by one person of a right, property or debt (existing or future) to another person. The person who assigns the right, property or debt is called the assignor. The person to whom the right etc. is assigned is called the assignee.

Common assignment:

1. Book debts/ Account Receivables (A/R);
2. Contract money due from Govt./Semi Govt. bodies;
3. Supply bills;
4. Life insurance policies.

Assignment is not a good security for the following reasons:

1. Assignment depends on the integrity and credit worthiness of assignor and his debtor.
2. In case of assignor's debtor exercise right of set off, assignee's position becomes vulnerable.
3. Right of assignee may be repudiated by breach of contract between assignor and his debtor.

Necessary precautions to be taken by Banks:

 Assignor to give irrevocable letter to debtor to pay debt to Banker,
 Banker must get assignment acknowledged by debtor.
 Banker must get clear notice for Prior assignment.
 Banker must send notice of assignment to debtor to prevent subsequent  assignment.
 Constant follow-up.
 Assignment for whole.

Set-off: Set-off means the total or partial merging of a claim of one person against another in a counter claim by the latter against the former. It is in effect the combining of accounts between a debtor and a creditor so as to arrive at the net balance payable to one or the other. It is a right, which accrues to the banker as a result of the banker customer relationship.

It is advisable to take prior letter of set-off so that a banker can combine them at its discretion without giving the customer any notice. It also serves as a proof that the bankers right of set-off exists and the customer has not waived it. However, in actual practice the bank sends a notice to the customer as soon as the right of set-off is exercised.

In the following situations where the banker's right of set-off automatically accrues and no notice of set-off is necessary:

1. On the death, insanity or insolvency of the customer.
2. On the insolvency of a partner of a firm.
3. On receipt of a garnishee order.
4. On the winding up of a company.
5. On receipt of notice of assignment of the credit balance of the customer.

Wrap up- Banking industry has significant role to play in the economic development of a country. The banker would lend if the purpose of the advance is for overall national development plans necessitating flow of credit to priority sector in the larger national interest. Sometimes the need of the borrower may be considered so essential for the benefit of the national economy that despite heavy risks involved the advance may be granted.

 

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