Forms of Lending

By Ashra Rehmat

Contents

• Principles of Lending• Form of Lending– Cash Finance (Cash Credit)– Overdraft – Loans (Term Finance)– Purchase and Discounting of Bills– Hire-purchase and Leasing Finance

PRINCIPLES OF SOUND LENDING

Safety

Liquidity

Profitability

SecurityDiversification of risks

Remuneration

SAFETY

• When a loan or investment is made, the banker will have to ensure that the money advanced is returned by the borrower along with interest within the predetermined period.

• This is possible only when the borrower does not face any risk & strictly stick to the terms & conditions of the loan.

• For this purpose, the banker will have to chose such type of borrowers who are prompt in repayment of the principal and interest amount.

LIQUIDITY

• The banker while making advances must see that the money he is lending is not going to be locked up for a long time, which should make his loans & advances less liquid & more difficult to realize in cases of emergency.

• An asset is said to be liquid when it can be converted into cash within a short notice, without loss. As the bank is investing or lending the depositors’ money, it has to take more precaution while doing so. The depositor may demand his/her money at any time & the bank must be in a position to repay the same.

SECURITY

• The banker should ensure that the borrower has the ability & will to repay the advances as per agreement.

• Before granting a secured advance the banker should carefully consider the margin of safety offered by the security concerned & possibilities of fluctuations in its value. If it is an unsecured advance, its repayment depends on the creditworthiness of the borrower, & that of the guarantor, wherever applicable.

DIVERSIFICATION OF RISKS

• The banker should aim at spreading the advances as widely as possible over different industries & different localities.

• This would enable him to compensate any losses which might arise as a result of unexpected factors adversely affecting particular industries and/or particular localities.

• Dispersal of advances is very necessary from the point of security as well, because it reduces risk of recovery.

Remuneration

• The banker need sufficient earnings to meet the following besides others:– Return payable to money deposited with it– To meet various statutory monitory requirements

under the banking law.– Salaries and benefits payable to staff members.– Payment of dividends to shareholders.

Forms of Lending

o Cash Finance (Cash Credit)o Overdraft o Loans (Term Finance)o Purchase and Discounting of Billso Hire-purchase and Leasing Finance

Cash Finance (CASH CREDIT)

• A Cash Credit is a very common form of borrowing by commercial and industrial concerns, and it is made available either against pledge or hypothecation of good.

• In cash finance, a borrower is allowed to borrow money upto a certain limit, either at once or as and when required.

• The borrower prefer this form of lending due to the facility of paying markup or service charges only on the amount he actually utilizes.

OVERDRAFTS

• When a customer requires temporary adjustment, he may be allowed to overdraw his current account. This arrangement like the cash credit is advantageous as he is required to pay interest on the amount actually used by him. – Secured overdraft– Clean overdraft

• The main difference between cash credit & overdraft is the latter is supposed to be a form of bank credit to be made use of occasionally & the former is used for long terms by commercial & industrial concerns doing regular business.

LOANS

• In case of loan, the banker advances a lump sum for a certain period at an agreed rate of interest.

• The entire amount is paid on an occasion either in cash or by credit in his current account which he can draw at any time.

• The interest is charged for the full amount sanctioned whether he withdraws the money from his account or not.

• The loan may be repaid in instalments or at the expiry of a certain period. The loan may be made with or without security.

• A loan once repaid in full or in part cannot be withdrawn again by the customer. In case a borrower wants further loan, he has to arrange for a fresh loan.

Two categories of loan

• Unsecured loans are those loans which are not covered by the security of tangible assets. Such loans are granted to firms/institutions against the personal security of the owner, manager or director.

• Secured loans are those which are granted against the security of tangible assets, like stock in trade and immovable property. Thus, while granting loan against the security of some assets, a charge is created over the assets of the borrower in favor of the bank. This enables the bank to recover the dues from the customer out of the sale proceeds of the assets in case the borrower fails to repay the loan.

Unsecured Secured

TERM LOAN

• Where a loan is granted for a period exceeding one year & is repayable according to a schedule of repayment, as against on demand & at a time is known as ‘term loan’.

• Where the period exceeds one year but not, 5 to 7 years, it is known as ‘medium term loan’.

• A loan with longer repayment schedule is known as ‘long term loan’.

PARTICIPATION LOAN or CONSORTIUM ADVANCE

• Where single loan is granted by more than one financing agency, it is termed as a participation or consortium loan.

• The assets or the securities of the borrower are charged jointly and severally in the same ratio as the contribution of participating bank.

• This system is now been quite popular in Pakistan also.

Purchase and Discounting of bills

• The banker advances money on the security of bills of exchange after deducting a certain percentage, technically known as ‘discount’, from the face value of the bill.– Documentary bills of exchange– Clean bills of exchange– Demand bills of exchange– Usance bills of exchange

• When discounting , the banks deduct amount at mentioned discount rate and balance is paid to the party.

Hire-purchase and Leasing Finance

• Sometimes an intending purchaser has no money sufficient to purchase a certain transport vehicle, machinery, computers or other durable consumer goods.

• Therefore, banks provide finance to hire purchase or lease the needed goods.

Thank You!