Principles of Sound Lending Policy
It is a fundamental precept of banking everywhere that advances are made to customers in reliance on his promise to repay, rather than the security held by the banker. Although all lending involves some degree of risks, it is necessary for any bank to develop sound and safe lending policies and new lending techniques in order to keep the risk to a minimum. As such, the banks are required to follow certain principles of sound lending.
(a) Safety: Advances should be expected to come back in the normal course. The repayment of the loan depends upon the borrower’s capacity to pay and willingness to pay. The capacity depends upon the tangible assets of the borrower. The willingness to pay depends upon the honesty and character of the borrower.
(b) Liquidity: Liquidity is the availability of bank funds on short notice. The borrower must be in a position to repay within a reasonable time. Liquidity also signifies that the assets should be scalable without any loss.
(c) Profitability: A banker has to see those major portions of the assets owned by it are not only liquid but also aim at earning a good profit. The difference between the interest received on advances and the interest paid on deposits constitutes a major portion of bank’s income. Besides, foreign exchange business is also highly remunerative.
(d) Purpose: A banker would not throw away money for any purpose for which the borrower wants. The purpose should be productive so that the money not only remains safe but also provides a definite source repayment.
(e) Security: Security serves as a safety valve for an unexpected emergency. The security offered for an advance is a cushion to fall back upon in case of need. An element of risk is always present in every advance however secured it might appear to be.
(f) Spread/ Diversity: The advances should be as much broad-based as possible and must be in keeping with the deposit structure. The advances must not be in one particular direction or to one particular industry. Again, advances must not be granted in one area alone.