4.

1 Principles of Lending and Loan policy

4.1.1 Principles of lending
To lend, banks depend largely on deposits from the public. Banks act as custodian of
public
deposits. Since the depositors require safety and security of their deposits, want to
withdraw
deposits whenever they need and also adequate return, bank lending must
necessarily be
based on principles that reflect these concerns of the depositors. These principles
include:
safety, liquidity, profitability, and risk diversion.

Safety
Banks need to ensure that advances are safe and money lent out by them will come
back.
Since the repayment of loans depends on the borrowers' capacity to pay, the banker
must be
satisfied before lending that the business for which money is sought is a sound one. In
addition,
bankers many times insist on security against the loan, which they fall back on if
things go
wrong for the business. The security must be adequate, readily marketable and free of
encumbrances.
Liquidity
To maintain liquidity, banks have to ensure that money lent out by them is not locked
up for
long time by designing the loan maturity period appropriately. Further, money must
come
back as per the repayment schedule. If loans become excessively illiquid, it may not
be
possible for bankers to meet their obligations vis--vis depositors.

Profitability
To remain viable, a bank must earn adequate profit on its investment. This calls for
adequate
margin between deposit rates and lending rates. In this respect, appropriate fixing of
interest
rates on both advances and deposits is critical. Unless interest rates are competitively
fixed
and margins are adequate, banks may lose customers to their competitors and
become
unprofitable.
Risk diversification
To mitigate risk, banks should lend to a diversified customer base. Diversification
should be in
terms of geographic location, nature of business etc. If, for example, all the borrowers
of a
bank are concentrated in one region and that region gets affected by a natural
disaster, the
bank's profitability can be seriously affected.
4.1.2 Loan Policy
Based on the general principles of lending stated above, the Credit Policy Committee
(CPC) of
individual banks prepares the basic credit policy of the Bank, which has to be
approved by the
Bank's Board of Directors. The loan policy outlines lending guidelines and establishes
operating
procedures in all aspects of credit management including standards for presentation
of credit
proposals, financial covenants, rating standards and benchmarks, delegation of credit
approving
powers, prudential limits on large credit exposures, asset concentrations, portfolio
management,
loan review mechanism, risk monitoring and evaluation, pricing of loans, provisioning
for bad
debts, regulatory/ legal compliance etc. The lending guidelines reflect the specific
bank's lending
strategy (both at the macro level and individual borrower level) and have to be in
conformity
with RBI guidelines.
The loan policy typically lays down lending guidelines in the following
areas:
Level of credit-deposit ratio
Targeted portfolio mix
Hurdle ratings
Loan pricing
Collateral security

Credit Deposit (CD) Ratio

A bank can lend out only a certain proportion of its deposits, since some part of
deposits have
to be statutorily maintained as Cash Reserve Ratio (CRR) deposits, and an additional
part has
to be used for making investment in prescribed securities (Statutory Liquidity Ratio or
SLR
requirement).24 It may be noted that these are minimum requirements. Banks have the option
of having more cash reserves than CRR requirement and invest more in SLR securities than
they are required to. Further, banks also have the option to invest in non-SLR securities.
Therefore, the CPC has to lay down the quantum of credit that can be granted by the bank as
a percentage of deposits available. Currently, the average CD ratio of the entire banking
industry is around 70 percent, though it differs across banks. It is rarely observed that banks
lend out of their borrowings.
Targeted Portfolio
Mix

The CPC aims at a targeted portfolio mix keeping in view both risk and return. Toward this
end, it lays down guidelines on choosing the preferred areas of lending (such as sunrise
sectors and profitable sectors) as well as the sectors to avoid.25 Banks typically monitor all
major sectors of the economy. They target a portfolio mix in the light of forecasts for growth
and profitability for each sector. If a bank perceives economic weakness in a sector, it
would restrict new exposures to that segment and similarly, growing and profitable sectors of
the economy prompt banks to increase new exposures to those sectors. This entails active
portfolio management.
Further, the bank also has to decide which sectors to avoid. For example, the CPC of a bank
may be of the view that the bank is already overextended in a particular industry and no more
loans should be provided in that sector. It may also like to avoid certain kinds of loans
keeping in mind general credit discipline, say loans for speculative purposes, unsecured
loans, etc.
Hurdle
ratings
There are a number of diverse risk factors associated with borrowers. Banks should have a
comprehensive risk rating system that serves as a single point indicator of diverse risk factors
of a borrower. This helps taking credit decisions in a consistent manner. To facilitate this, a
substantial degree of standardisation is required in ratings across borrowers. The risk rating
system should be so designed as to reveal the overall risk of lending. For new borrowers, a
bank usually lays down guidelines regarding minimum rating to be achieved by the borrower
to become eligible for the loan. This is also known as the 'hurdle rating' criterion to be achieved
by a new borrower.

Pricing of
loans
Risk-return trade-off is a fundamental aspect of risk management. Borrowers with weak financial
position and, hence, placed in higher risk category are provided credit facilities at a higher
price (that is, at higher interest). The higher the credit risk of a borrower the higher would be
his cost of borrowing. To price credit risks, banks devise appropriate systems, which usually
allow flexibility for revising the price (risk premium) due to changes in rating. In other words,
if the risk rating of a borrower deteriorates, his cost of borrowing should rise and vice versa.
 At the macro level, loan pricing for a bank is dependent upon a number of its cost factors such
as cost of raising resources, cost of administration and overheads, cost of reserve assets like
CRR and SLR, cost of maintaining capital, percentage of bad debt, etc. Loan pricing is also
dependent upon competition.
Collateral
security
As part of a prudent lending policy, banks usually advance loans against some security. The
loan policy provides guidelines for this. In the case of term loans and working capital assets,
banks take as 'primary security' the property or goods against which loans are granted.26 In
addition to this, banks often ask for additional security or 'collateral security' in the form of
both physical and financial assets to further bind the borrower. This reduces the risk for the
bank. Sometimes, loans are extended as 'clean loans' for which only personal guarantee of the
borrower is taken.
4.1.3 Compliance with RBI
guidelines

The credit policy of a bank should be conformant with RBI guidelines; some of the important
guidelines of the RBI relating to bank credit are discussed below.
Directed credit stipulations
The RBI lays down guidelines regarding minimum advances to be made for priority sector
advances, export credit finance, etc.27 These guidelines need to be kept in mind while formulating
credit policies for the Bank.
Capital adequacy
If a bank creates assets-loans or investment-they are required to be backed up by bank
capital; the amount of capital they have to be backed up by depends on the risk of individual
assets that the bank acquires. The riskier the asset, the larger would be the capital it has to be
backed up by. This is so, because bank capital provides a cushion against unexpected
losses of banks and riskier assets would require larger amounts of capital to act as
cushion.

The Basel Committee for Bank Supervision (BCBS) has prescribed a set of norms
for the capital requirement for the banks for all countries to follow. These norms
ensure that capital should be adequate to absorb unexpected losses.28 In addition, all
countries, including India, establish their own guidelines for risk based capital
framework known as Capital Adequacy Norms. These norms have to be at least as
stringent as the norms set by the Basel committee.
A key norm of the Basel committee is the Capital Adequacy Ratio (CAR), also known as
Capital Risk Weighted Assets Ratio, is a simple measure of the soundness of a bank. The
ratio is the capital with the bank as a percentage of its risk-weighted assets. Given the
level of capital available with an individual bank, this ratio determines the maximum
extent to which the bank can lend.
The Basel committee specifies a CAR of at least 8% for banks. This means that the
capital funds of a bank must be at least 8 percent of the bank's risk weighted assets.
In India, the RBI has specified a minimum of 9%, which is more stringent than the
international norm. In fact, the actual ratio of all scheduled commercial banks (SCBs) in
India stood at 13.2% in March 2009.
The RBI also provides guidelines about how much risk weights banks should assign to
different classes of assets (such as loans). The riskier the asset class, the higher
would be the risk weight. Thus, the real estate assets, for example, are given very high
risk weights.
This regulatory requirement that each individual bank has to maintain a minimum
level of capital, which is commensurate with the risk profile of the bank's assets, plays a
critical role in the safety and soundness of individual banks and the banking system.

Credit Exposure
Limits
As a prudential measure aimed at better risk management and avoidance of
concentration of credit risks, the Reserve Bank has fixed limits on bank exposure to the
capital market as well as to individual and group borrowers with reference to a bank's
capital. Limits on inter-bank exposures have also been placed. Banks are further
encouraged to place internal caps on their sectoral exposures, their exposure to
commercial real estate and to unsecured exposures.

Regulations relating to
providing loans
The provisions of the Banking Regulation Act, 1949 (BR Act) govern the making of
loans by banks in India. RBI issues directions covering the loan activities of banks. Some
of the major guidelines of RBI, which are now in effect, are as follows:
 Advances against bank's own shares: a bank cannot grant any loans
and advances against the security of its own shares.

Advances to bank's Directors: The BR Act lays down the restrictions

on loans and advances to the directors and the firms in which they hold
substantial interest.

Restrictions on Holding Shares in Companies: In terms of Section

19(2) of the BR Act, banks should not hold shares in any company except as
provided in sub-section (1) whether as pledgee, mortgagee or absolute owner,
of an amount exceeding 30% of the paid-up share capital of that company or
30% of its own paid-up share capital and reserves, whichever is less.