The principles of sound lending by commercial banks are:
Banks should follow some basic principles at the time of lending. This ensures efficient and long term working of the banks. Some of the basic principles of lending are as follows:
1. Safety of principal: The first and foremost principle of lending is to ensure the safety of the funds lent. It means that the borrower is in a position to repay the loans, along with interest, according to the terms of the loan contract. The repayment of the loan depends upon the borrower’s
i. capacity to pay and
ii. willingness to pay.
The banker should, therefore, take utmost care in ensuring that the enterprise or business to which a loan in to be granted is a sound one and the borrower is capable to repay it successfully.
2. Profitability: Commercial banks are profit earning institutions. They must employ their funds profitably so as to earn sufficient income out of which to pay interest to the depositors, salaries to the staff and to meet various other establishment expenses and distribute dividends to the shareholder. The sound principle of lending does not sacrifice safety or liquidity for the sake of higher profitability.
3. Marketability or Liquidity: Liquidity of loans is another principle of sound lending. The term liquidity of loan indicates quick realisation of loans from the borrowers. Banks are essentially dealers in short term funds and therefore, they lend money mainly for short term period. The banker should see that the borrower is able to repay the loan on demand or within a short notice.
4. Purpose of the loan: Before granting loans, the banker should examine the purpose for which the loan is demanded. If the loan is granted for productive purpose, thereby the borrower will make much profit and he will be able to pay back the loan. In no case, loan is granted for unproductive purpose.
5. Diversification: The element of risk in relation to loans cannot be totally eliminated, it can only be reduced. Risks of lending can be reduced by diversifying the loans. While granting loans, the banker should not grant a major part of the loan to one single particular person or particular firm or an industry. If the banker grants loans and advances to a number of firms, persons or industries, the banker will not suffer a heavy loss even if a particular firm or industry does not repay the loan.
6. National policies: Banks have certain social responsibilities towards society also. The banks have to take into account the economic and social priorities of the country beside safety, liquidity and profitability. While formulating the lending policy, the banks are guided by the government policies in relation to disbursal of credit. Thus, national interest and policies are influence the lending decisions of banks.
- In conclusion, it may be said that due consideration of all the principles are necessary, while evaluating a loan proposal.