Principles of Bank Lending and the Types of Credit Facility

A bank lends money it does not own. Every rule about how it lends is traceable to that single fact, from the canons of lending taught to every trainee to the exposure norms imposed by the Reserve Bank. This note deals with why a bank lends as it does, how it decides whether to lend at all, and what forms the lending actually takes, which is the necessary background to the law of bank securities.

1. The Canons of Lending

Figure 1: The considerations that govern every advance

• Safety: the first principle, because the money advanced belongs to depositors. The question is not whether the borrower is honest but whether the advance will be repaid in full with interest, from a source the bank can identify in advance.
• Liquidity: a bank's liabilities are mostly short term and its assets mostly longer term. Advances must therefore be capable of realisation when depositors call, which is why self liquidating advances against stocks and bills were historically preferred to long term lending.
• Profitability: the spread between the cost of funds and the lending rate must cover the cost of funds, the expected credit loss, the operating cost and a return on capital. A loan priced below that destroys value however safe it is.
• Purpose: the bank must know what the money is for, because the purpose indicates the source of repayment. An advance for speculation, for repaying another lender or for an undisclosed purpose has no identifiable source of repayment.
• Diversification: concentration in one borrower, one group, one industry or one region makes the bank's fortunes depend on a single event. The large exposures framework turns this canon into a binding limit.
• Security: a cushion, not a substitute for appraisal. A loan made because the security is good, without regard to whether the borrower can repay, is a bad loan with good collateral.
• National interest: the Indian addition. Priority sector obligations and directed credit mean that a bank's lending decisions are not purely commercial, and Section 21 of the Banking Regulation Act gives the Reserve Bank power to determine the policy on advances.

2. Credit Appraisal

Figure 2: The credit cycle from enquiry to monitoring

• The borrower: character, capacity and capital, assessed from the track record, the conduct of existing accounts, credit information reports and the promoters' own stake. A borrower with nothing of his own at risk behaves differently from one who has a great deal.
• The proposal: collateral and conditions, that is the security offered and the economic and industry environment in which the borrower will have to perform.
• Technical and financial appraisal: whether the project is capable of being built and run, and whether the projected cash flow services the debt with a margin. The debt service coverage ratio and the debt to equity ratio are the usual tests.
• Credit information: reports from credit information companies under the Credit Information Companies (Regulation) Act, 2005, the central repository of information on large credits, and the lists of wilful defaulters.
• Rating and pricing: an internal credit rating determines the risk premium over the benchmark, and since 1 October 2019 floating rate loans to individuals and to micro and small enterprises must be linked to an external benchmark.
• Sanction and documentation: sanction within delegated authority on stated terms, followed by execution of the loan documents, creation of security, and registration of the charge where the borrower is a company or where the central registry requires it.
• Monitoring: inspection of the securities, periodical stock and book debt statements, scrutiny of the operation of the account, and attention to early warning signals such as a sudden fall in turnover, delay in submitting statements, or diversion of funds.

3. The Forms of Credit Facility

• Term loan: a fixed sum repayable over a stated period in instalments, used for acquiring an asset or building a project. The security is ordinarily a mortgage of the immovable property and a hypothecation of the plant and machinery.
• Cash credit: a running account against the security of stocks and receivables, up to a sanctioned limit, on which the borrower pays interest only on the amount actually used. It is the traditional Indian working capital facility, and the rule in Clayton's case applies to it.
• Overdraft: permission to draw beyond the credit balance of a current account, either as a temporary accommodation or against security such as a term deposit or securities.
• Bill finance: purchase of a demand bill or discounting of a usance bill, under which the bank pays the seller at once and recovers from the buyer at maturity. It is self liquidating and tied to a specific trade transaction.
• Letter of credit: an undertaking by the bank to pay the seller against documents. The bank's exposure is contingent until the documents are presented.
• Bank guarantee: an undertaking to pay the beneficiary on demand if the customer defaults, used for performance obligations, earnest money, advance payments and statutory requirements.
• Why the distinction matters: a non-fund based facility appears as a contingent liability in the notes to the accounts and is converted into a funded equivalent for capital purposes by a credit conversion factor. Once invoked, it becomes an ordinary funded advance.

4. Working Capital Assessment

• The need: a business must pay for raw material, wages and overheads before it is paid for the finished goods. The gap is the working capital cycle, and bank finance bridges it.
• The Tandon Committee (1975): laid down norms for inventory and receivables, required the borrower to contribute a share of the working capital gap from long term sources, and offered three methods of computing maximum permissible bank finance, with the borrower's contribution rising from the first method to the third. The first two were put into practice.
• The Chore Committee (1979): recommended reducing dependence on cash credit, requiring borrowers to submit quarterly information, and placing the borrower's use of the limit under closer discipline.
• The Nayak Committee (1991): for small borrowers, a turnover method, under which the working capital requirement is taken at 25 per cent of projected annual turnover, of which 20 per cent is financed by the bank and 5 per cent is contributed by the borrower as margin. It is still used for smaller limits because it is simple to apply.
• Deregulation: the Reserve Bank withdrew the prescriptive norms and left banks free to evolve their own methods of assessment through a board approved policy. The committee methods survive as practice rather than as regulation.
• Loan system for delivery of credit: for large borrowers the Reserve Bank requires part of the working capital limit to be in the form of a loan component rather than a running cash credit, so that the bank can plan its liquidity rather than bear the unpredictability of drawings.
• Drawing power: within the sanctioned limit, the borrower may draw only against eligible stocks and receivables after deducting the prescribed margin and the creditors for those stocks. The stock statement is therefore the operative control.

5. Lending by More Than One Bank

• Consortium lending: several banks lend to one borrower under a common agreement, with a lead bank appraising, documenting and monitoring on behalf of all, and a common security shared pari passu. The borrower deals with one bank; the lenders share the risk.
• Multiple banking: the borrower takes facilities from several banks independently, each with its own appraisal, documents and security. It is simpler for the borrower and more dangerous for the lenders, since none of them sees the whole picture.
• The information problem: multiple banking made possible the practice of borrowing against the same stocks from more than one bank. The answers have been mandatory exchange of information among lenders, registration of charges with the central registry under the SARFAESI Act, and the requirement that a borrower declare existing facilities.
• Syndication: a lead arranger structures the facility and sells participations to other lenders, each of whom has a direct contractual relationship with the borrower under a single agreement. It is the market form of consortium lending.
• Joint lending and inter-creditor agreements: for stressed accounts, the Reserve Bank's framework requires lenders to enter into an inter-creditor agreement and to agree a resolution plan within prescribed timelines, with a majority binding the rest.

6. Questions Arising

If security is taken, why does appraisal matter?

Because security is a second way out, not the first. Realising it costs time and money, its value falls precisely when the borrower's industry is in trouble, and a bank that has to enforce has already lost the interest income it lent for. The security exists to limit the loss if the appraisal proves wrong, and a loan made on the strength of the collateral alone is simply a slower form of bad lending.

Why does the Reserve Bank require part of a working capital limit to be a loan?

Because a pure cash credit limit leaves the bank unable to predict its own cash needs: the borrower may draw the whole limit on any day without notice, and the bank must hold liquidity against that possibility. Converting part of the limit into a loan component with a fixed tenor gives the bank certainty, improves the transmission of policy rates, and makes the borrower plan his own requirement rather than treat the limit as an overdraft.

7. Quick Revision

8. Frequently Asked Questions

What are the principles of sound bank lending?

Safety, because the money lent belongs to depositors; liquidity, because the bank's own liabilities are repayable on demand; profitability, because the spread must cover cost, risk and capital; purpose, because the purpose indicates the source of repayment; diversification, to avoid concentration; security, as a cushion rather than a substitute for appraisal; and national interest, which in India takes the form of priority sector obligations.

What is the difference between a cash credit and an overdraft?

A cash credit is a running account sanctioned as a working capital facility against the security of stocks and receivables, with drawing power controlled by stock statements. An overdraft is permission to draw beyond the balance of a current account, either as temporary accommodation or against security such as a term deposit. Both are running accounts, but the cash credit is tied to the borrower's trading assets.

What is a non-fund based facility?

One in which the bank undertakes an obligation but parts with no money at the outset, such as a letter of credit or a bank guarantee. The bank earns commission rather than interest, the exposure appears as a contingent liability in the notes to the accounts, and it is converted into a funded equivalent for capital purposes by a credit conversion factor. On invocation it becomes an ordinary funded advance.

What was the contribution of the Tandon Committee?

It laid down norms for holding inventory and receivables, required the borrower to fund part of the working capital gap from long term sources, and set out three methods for computing the maximum permissible bank finance, with the borrower's contribution increasing from the first method to the third. The norms were later withdrawn as a regulatory requirement, but the approach survives in banks' own assessment policies.

What is the difference between consortium and multiple banking?

In consortium lending several banks lend under a common agreement, with a lead bank appraising and monitoring for all and the security shared pari passu. In multiple banking the borrower deals with each bank independently, with separate appraisals, documents and securities, so no lender sees the whole exposure. The second is simpler for the borrower and far riskier for the lenders.

9. Related Topics and Provisions

• Securities for advances: lien and pledge
• Hypothecation and mortgage
• Guarantee and indemnity in bank lending
• Priority sector lending and directed credit
• Restrictions on loans and advances (Sections 20 and 21)
• Non-performing assets and the recovery statutes