11 Principles of Sound Lending
Earning profit by providing loans is customary from the initial stage of the banking business to date. The more efficiently a bank can manage loan activities, the more profit-making will be possible. A major portion of a bank’s profit would have been earned from loan activities even two decades ago.
But recently, commercial banks have focused more than before on non-loan activities and render many innovative services to raise the profit level compared to the competitors. Banks distribute a reasonable portion of the depositors’ money as loans to the borrowers.
Of course, the loanable funds are determined after maintaining sufficient liquidity for the depositors and reserve as directed by the regulatory authorities.
Lending depositors’ money to third persons is risky; banks also require to pay interest to the depositors on their deposit amounts. Loan activities must be operated on the risk-minimizing and income-augmenting approach and other important factors.
Establishing a loan policy is one of the most important ways a bank can ensure its loans meet regulatory standards and become profitable.
Such a policy gives the loan officers and the bank s management specific guidelines for making individual loan decisions and shaping the bank s overall loan portfolio. The actual makeup of a bank’s loan portfolio should reflect what its loan policy hints at.
Otherwise, the loan policy is ineffective and should be revised or more strongly enforced.
What should a bank’s loan policy contain? Important elements of an efficient loan policy, among others, include the points as under:
- A goal statement – types, maturities, sizes, quality, etc.;
- Lending authority – who can sanction how much;
- Lines of responsibility- assignments and reporting;
- Operating procedures- application to the final stage of the decisions;
- Guidelines relating to collateral;
- Pricing strategies;
- Basis of judging loan status;
- Guidelines for supervision, monitoring, recovery drives; and
- Guidelines to handle problem loans.
In the following section, we will see some of the principles following which loan activities can be made proper, pragmatic, and realistic.
What Are The 11 Principles of Sound Lending?
Purpose of Loan
Banks should analyze whether the purposes of the loan meet the scope and loan policies of the bank. Banks also need to analyze and monitor whether the purpose of the loan will have the sufficient cash flow to repay the loan amount.
Technically, the purpose must be viable and able to cam adequate profit for the borrower; else, the loan recovery may be difficult.
Safety should get the prior importance while sanctioning the loan. At maturity, the borrower may be unable to repay the loan amount. Banks should not sacrifice safety for safety depends upon the:
- The quality of the security offered by the borrower; and
- The repaying capacity and willingness of the borrower to repay the principal amount of the loan along with interest.
The bank’s social responsibility is to meet the loan demand of the locality where it operates its business. To increase goodwill, banks need to perform other social activities as well.
Though providing loans is the main source of a bank’s income, banks should not give loans for immoral or unethical purposes like the establishment of brothels or illegal drug businesses.
Spread And Risk Diversification
Bankers should minimize the portfolio risk by putting their funds in a different well-thought portfolio; if banks invest in one customer/sector, risk will be increased.
Bankers should distribute their investments to different customers/ sectors. So, if it faces any problem in any sector, it can be covered by the profit of another sector.
Loan activities must be maintained according to the national priorities upholding the rules and regulations of the central bank and other bank regulatory authorities.
Before sanctioning the loan, the bank should consider the economic position of the country and government policy for the allocation of Inflation. 5-year planning of government and tax principles dominate the loan decision of the banks.
The possibility of recovering the loan at maturity needs to be measured before sanctioning the loan to the borrower. Recovery must be ensured before sanction.
Liquidity is a must for loan operations. The banker should consider liquidity when sanctioning the Liquidity to meet the depositors’ requirements, disburse sanctioned loans, and payments for recurring expenses.
Profit And Profitability
Like other businesses, the bank’s main purpose is to maximize the difference between providing interest on a deposit and the earned interest on the loan is the main criterion for making a traditional profit.
The interest rate should be cautiously determined. Clients will leave for other banks if the bank charges a higher rate.
If the rate is lower, it will be insufficient to cover the cost of the fund. So, setting the interest is not easy; it would be performed by efficient and active personnel- experience may play a better role.
As a profitable institution, the bank needs to maintain its long-term solvency. Banks must be able to meet the demand for deposits.
For this, the bank needs to maintain a certain amount of reserve. On the other hand, the loan amount should be sufficient to make a profit by satisfying the borrower’s demand and meeting other expenses.
Bankers should be careful in selecting security to maintain the safety of the money sanctioned as a loan.
The banner should properly evaluate the actual/approximate realizable value of the security if the sale value is to the minimum less than or equal to the loan amount the loan may be given against such securities.
The more near-cash items or easily convertible, the better the quality of the security is. When valuing security, the banker should be more conservative.