I discussed previously investment management and its everything. Now, in this article, you are going to know everything about loan management.
What is Meant by Loan?
Like any other business organizations, commercial banks are established also for the purpose of earning a profit. The main profit-earning activity of banks is to earn interest income or profit from extending loans of the funds mobilized as deposits. As such loans extended, both interest and principal must be recovered on time in order to keep the depositors’ money safe and also to maintain the revolving character of funds so utilized as loans. It is, therefore, imperative that commercial banks should not provide loans without properly analyzing the creditworthiness in order to ensure the recovery of money so lent. Can you guess now what is meant by loan? Let’s
Over time, some principles, procedures and theories have been developed, innovated and practised. The main purpose of all of these is to facilitate lending in an easy but pragmatic way in order to ensure the revolving character of the funds to maximize profit earning. At the very outset, a loan officer must be clear about the meaning & definition of loans, features and functions and their types along with operational mechanisms. The officer to be sure about the extent of risk and recoverability must take into account all the possible information relating to the loan applicant and also about the socio-economic viability of the project for which loan is sought. The officer then attempts to focus on the pricing of the loan after assessing the costs of funds and the expected rate Of return from the loans.
At one time, a bank officer only had to track the fortunes of a handful of large, well-known companies as borrowers. The skills needed for this kind of analysis centred on understanding the qualitative aspects of a business. While fundamental analysis on understanding continues to have a place in understanding an obligor’s credit quality, the name of the credit business has changed. Narrowly focused, simplistic standalone credit analysis is no longer enough.
In real life, individuals or institutions (business/non-business or government/non-government) face some situations when they feel the necessity of collecting, achieving or using something for which they may not have adequate required purchasing power. On the other hand, there are individuals or institutions that have surplus funds after fulfilling both of their recurring and investment requirements. By way of deposit, the bank takes these surplus funds in its own custody. The bank again temporarily transfers these funds for a specific duration in exchange of some interest/profits to those who do not have required purchasing power but have the capacity to utilize borrowed funds for some productive & profitable purposes/projects. Here, “temporarily” means that the user will return the “provided purchasing power” as loans after some time as per the terms of the contract.
However, in the banking arena, many types of financial facilities are extended to the clients with the expectation of getting the same returned along with interest. This “provided purchasing power” can be termed as loan, credit or advance. These three terms have similarities as well as some differences. In this topic, we assume that these three terms are similar and we will term these as “loans”.
Banks can provide loans in different ways. Loans can be in cash or in non-cash form. If any client takes advantage from the bank by using the bank‘s goodwill through making a contract, this will be treated as “goodwill loan” of the bank. UC, traveller’s cheques, and traveller’s notes are the “goodwill loan” of a bank. ‘
According to the Dictionary of Banking & Finance, loans can be defined as “the lending of a sum of money by a lender to a borrower to be repaid with a certain amount of interest
Timothy W Koch defined loans as. “a formal agreement between a bank and borrower to provide a fixed amount of credit for a specified period.”
According to the author “Loans may be defined as money lent at interest or on profit. It is nothing but temporarily parting with one’s (an individual or an institution) resources in order to augment the purchasing power of the receiver of such facility with a promise to return the same with interest/profit or otherwise as mutually agreed upon”.
From the above discussion, we can easily say that as a profit-oriented business organization, if a bank gives its resources temporarily under certain conditions and for a specific duration, it will be called the loan. Time to time, the term, credit and advance are used separately in different spheres.
Loan vs Investment
Loan vs Investment: Both loan and investment are examples of the utilization of bank funds. Banks provide credit to the clients and earn interest from it. On the other hand, if banks have excess loanable funds, they may invest in a money market or capital market instruments and earn dividends, interest or bonus share. Sometimes we need to distinguish the difference between loan and investment.
However, there are some key differences between loan and investment. In the following sections, we will try to identify these:
Difference Between Loan and Investment
|Point of Differences||Loan||Investment|
|Transaction type||Debt transaction||Mostly unique transaction|
|Contacts||Direct||Indirect and impersonal|
|Knowledge of Maturity Period||Known to the borrower and other interested parties||Except for debentures, not known in other types of instruments|
|Term||May vary from several days to even 40 years||Depends on the investment policy of the banks|
|Negotiation||Based on views of both bankers & borrowers||No scope for discussion as all the terms & condition are pre-fixed and not negotiable|
|Purpose of the raised Funds||Landing banks are expressedly informed||Instrument purchasing/investing banks are not aware of.|
|Income source||Only interest and penal interest||Dividends, bonus share, light share, capital appreciation gains, etc. But, for debenture, interest only.|
|Operation Area||Mostly, within the command area||The operation area is wider, both national and international as well.|
|Intensity and Extent of risk||Except prime customers, most of the loans face the difficult risk||Risks depend on the types of instruments but the risk is comparatively lower than the risk of the loan.|
|Volume of fund||Except for industrial loan, most of the loans are of smaller volumes||Mostly, the volume of funds is larger.|
|Shiftability||Shifttability is very difficult (except securitization in some cases)||Shiftability relatively easier can be done even with some loss on conversion|
|Termination||Successfully termination depends on the willingness of the borrower||Terminated at the willingness of the bank/shareholder or holder of the debentures|
The above table shows the difference between investment and loan.
Characteristics of Bank Loan
Characteristics of Bank Loan; Bank loans have some unique characteristics according to purpose, usage and nature. The major features of the bank loan are given below:
- Parties: There are two waves of panic involved in loan transactions. One is the bank and the other is the loan applicant. Here, the applicant will apply for loans to the bank and bank will accept the application, if logical and will reject if found financially not viable.
- Amount of loan: mount may vary small, medium or large. There might be a difference between the applied amount and the sanctioned amount on the basis of the quality and capability of the borrower and purpose/ project for which applied
- Ultimate Decision: Banks’ decision is final in case of the loan application. That is, the bank can fully sanction, partially sanction or may totally reject the application after considering its own fund, goodwill of the clients and other issues in connection with judging creditworthiness. Loan distribution can be lump sum at a time or can be in installments. In determining the type, the bank can discuss with the potential borrower but the ultimate authority rests upon the bank only. Even the bank’s decision cannot be challenged in any court of law.
- Mode of Loan: Generally, loans are given in cash. But in exceptional cases, the same may be provided in kind, for example, raw materials, machinery, other inputs, etc.
- Nature of Distribution: Generally, banks disburse loans on an installment basis. But when the bank is convinced, it may disburse the whole amount of sanctioned loan at a time.
- Process of Disbursement: Banks often disburse their loan against the existing current account of the client. If the chem is new, the bank asks him/her to open a current account. Then, the bank provides the sanctioned loan through that account.
- Security: Generally, loans are sanctioned against collateral. But, sometimes a small number of loans can be sanctioned on the basis of personal guarantee.
- Loan Price: Banks never sanction loan without interest or profit. But, the interest rate can vary on the basis of types of loan or status and track records of the clients. Sometimes, at the time of providing some special loans, banks may take a small interest as “service charge”.
- Periodicity of Bank Loan: Depending on the types of loans, goodwill of the clients and purpose, periodicity of the loans can vary. Loans may be sanctioned for immediate use, short term, mid-term or long-term basis.
- Repayments of Loans: Loans are repaid on an installment basis or it may be a one-shot arrangement. In preparing the repayment schedule, banks generally, focus on the possible cash flow stream of the clients’ projects.
Functions of Bank Loan
Functions of Bank Loan; Loans cannot be collected without price. Nobody can afford to keep something idle and unproductive, which was purchased by paying a competitive price. Loans are usually taken by individuals or corporate houses. Functions of such bank loans include among others the following:
Functions of Bank Loan
|Provided to individuals||Provided to Business Organizations|
|a. Consumption Loan||a. Working Capital Loan|
|b. House Loan||b. Seasonal Deficit Loan|
|c. Automobile Credit||c. Economic Cycle Requirement Loan|
|d. Probate Loan||d. Asset Replacement Loan|
|e. Education and Medical Loan||e. Fixed Asset Acquisition Loan|
|f. Holiday Tour Loan||f. Bridge Loan|
|g. Wedding and Social Ceremony Loan||g. Export-Import Loan|
These points are described below:
Functions Provided to Individuals: Banks give loans to individuals in order to purchase the necessities, which they cannot buy with their limited financial means. The loans, which can be of the following types:
- Consumption Loan: Consumption demand for durable goods often individuals can not afford from regular personal inflows. Banks nowadays give loans for these purposes according to the needs of the customers. The loans may be granted to buy costly furniture, freeze, TV, color TV, computer, Laptop, etc. While extending such loans banks want to be sure that the potential borrowers have regular sources of adequate income.
- House Loan: People of limited income face problems in building their own houses. Banks provide home loans payable at the end of a specific term to people in exchange for some interest/profit. Thus banks succeed to a great extent in solving the housing problem of the urban people.
- Automobile Loan: Banks give loans to the customers to buy automobiles for commercial use or for personal use for comfort. Loans for private cars, office cars, trucks, buses, etc are included in such category.
- Private Loan: It is necessary to register the gifted/willed assets at the time of handover. The registration of such assets may be very costly for the person who receives the assets. In this case, banks on the assurance of the mortgage of the gifted property give loan in order to meet the registration expenses and thus help the client to acquire the asset.
- Education and medical loan: Education and medication are the two basic needs of human beings. Commercial banks sometimes provide loans to pursue studies or defray medicare expenses when becoming sure about the repayment from such clients
- Holiday Tour Loan: For Increasing the pleasure from the traveling & tour, banks provide holiday loan to those who have a definite source of adequate regular income.
- Wedding and social ceremony Loan: Man is a social being. Different rituals and social ceremonies are required to be observed in society. Sometimes, it is difficult for fixed income persons to bear the expenses of a wedding or any other ceremony. By providing loans, banks help such clients to bear the expenses required for performing such ceremonies.
Functions Provided to Business Organisations: Businessperson and business institutions ignite the economic progress of a country. Banks participate in this process by providing loans to business houses/organizations. Let’s discuss the purposes for which business organizations take such loans:
- Working Capital Loan: If the business organizations face problem in production due to lack of working capital mostly to procure raw materials, fuels, accessories, etc., banks help them by lending them money in order to arrange those and thus must the business organizations to increase production.
- Seasonal Deficit Loan: Some business organizations need more capital in some seasons because of great seasonal demand. Commercial banks provide loans for the deficit capital in order to buy raw materials and other related inputs.
- Economic Cycle Requirement Loan: In a recession, banks may need a loan to recover from the bad times. With this type of loan, production is increased. Employment and national income may also be increased. And at last, the economic condition of the country will be improved.
- Asset Replacement Loan: Business institutions need loans for replacement of fixed assets. This type of loan helps business organizations to repair and re-establish the torn out and old assets and machinery.
- Asset Acquisition Loans: In the light of competitors’ demonstration a business organization may plan to acquire newly developed machines or other assets for which bank may extend loans.
- Bridge Loans: Public limited companies are required to fulfil some formalities in order to be listed in the stock exchanges. When in short of funds they may require additional financing for the purpose. Banks, when finding reasonable, extend loans to such companies from raising money through new issues arrange to repay the loans taken. The purpose of this loan is to make the business organization capable of issuing shares.
- Export-Import Loans: Export-Import helps the economy to grow fast. The exporters and importers help to augment the volume of their businesses with additional loans by the banks. Banks also help these businesses houses by issuing L/C and even they stand by L/C for a particular period of time.
Importance of Loan
Importance of Loan; Now, you are gonna know the importance of a loan. A bank is an important tool for economic development in any country. Bank loans are required to use improved technology to increase the volume of production in the agriculture sector as well as to facilitate business activities. Researches support the fact that the economic & financial development of a country is highly correlated to the development of its banking & financial system. The more developed and efficient especially in the banking sector of a country is, the more developed & efficient in the business industry sectors will be. The primary sector like agriculture & farming is also a significant development on the banking system- quality inputs to be adequately arranged on time is largely determined by the supply of farm credit on easy terms & conditions.
Areas of the importance of loan are given below
Importance of bank loan in trade and commerce
- Creation of credit deposits.
- Increased formation of capital.
- The increased volume of investment of capital & working
- Raise the proportion of the sectoral GDP to the total GDP.
Importance of loan in international business
- Financing Export Import
- Discounting bill of Exchange,
- Bank draft etc.
- Regional development
Importance of loan in agriculture
- Crop credit
- Cash crop credit
- Horticulture credit
- Warehouse credit
- Rural housing credit
- Poultry and fisheries
- Small and cottage industries credit
- Improved technology credit
- improved seed credit
- Chemical fertilizer credit
- Other tools & machines credit
Importance of providing Consumption
- Housing loan
- Education loan
- Car loan
- Marriage loan
The purpose of this type of loan is to help unemployed but industrious young persons to be engaged in income-generating activities. The types are:
- Woman self-employment loan
- Technician self-employment loan
- Shop keeper self-employment loan
- Small Business self-employment loan
If we observe the above-mentioned activities, we can say that the bank loan is very much important for the economy of the country. Generally, these activities are operated to achieve two main objectives. Learn more about the types of loans.
- National priority directed loan activities
- Profit directed loan activities
Though the second types of activities are not sufficient for the banks to earn an instantly higher rate of profit but such types of loan activities improve the life standard and employment opportunity of the disadvantaged segment of the population. This will eventually increase the opportunity of collecting more deposits in the near future as well as will certainly raise the demand for loans in a larger number of bankable projects. So the importance of loan is important for any country, person, organization, etc.
Sources of Credit Information
Sources of Credit Information; Loans are sanctioned on the basis of the loan application. All the Loan cases are not processed only observing the loan amount or the purposes mentioned in the form of the loan application. Rather, the bank examines whether the purposes of loans are acceptable to banks. Bank makes this consideration to ensure the return of the loan amount. In the following above char, we may find the usual sources of credit information.
Now, I am describing these sources below:
Internal sources of credit information
- Application: Bankers may get information about the client by analyzing the filled in credit application form. It will be the first source of information for a new client.
- Interview: A banker can also get information by interviewing or directly contacting with the client and ask him/her the reasons for seeking credit, review the present financial position, types, and nature of the collateral, etc that the clients offer to propose.
- Financial Statements: If any business firm wants to take a loan from the bank, it has to submit its financial statements. From the financial statements, banks can get information regarding the trend of the financial position of the firm.
- Bank’s Own Record: If the client had previous transactions with the bank, the bank can get information about the client from the documents/records. The related information may be the practice of repaying the loan, the amount of deposit in the bank, the nature of banking activities, etc.
External sources of credit information
Banks can also collect various information from external sources. These sources are:
i) Government or regulatory authorities:
The government sets and establishes rules and regulations for controlling the business activities of the country. Records of such officers of the Govt. may serve as the source of required credit information:
- Income tax office: If a bank wants to know information regarding the tax payment by the potential borrower, it may seek information from the income tax office. In such terms amount and sources of income & expenditures are shown in order to assess the tax liability of the particular assess(s).
- Government Gazette: Bank can get periodic information if had any Govt. contact from the published gazette by the government.
- Records from the other govt. office: Bank can also get other information regarding the potential borrower from relevant other government offices with which the loan applicant had to move around for business connections.
- Registrar of joint-stock companies: Companies are required to get permission from the registrar of joint-stock companies in order to commence the business. Apart from this, public limited companies are also required to submit their annual financial statements duly audited to the registrar of joint-stock companies. If necessary, the bank may seek information about the client from the joint-stock registrar’s office.
ii) Other Sources
- Inspection: Bank may send one of its officials to visit physically and inspect the potential borrower’s working place or factory. By inspecting and physically investigating, the banker may collect necessary information regarding the clients.
- Market report: Banks may analyze the market potentiality of the business of the client from the report of the stock markets. The trends of share prices/dividend payouts, etc. help the bank to have knowledge about the success of the venture of the borrower, which ultimately ensures repayment of loan along with interest.
- Credit information bureau: CIB preserves the loan information of large business institutions or people who frequently approach loans. CIB can be another source of information for the banks.
- Newspaper: Bank may carefully analyze newspaper reports as appear in the commercial/ financial page to find information regarding the potential borrower. Sometimes, in the newspaper, exceptionally strong-weak information regarding the clients may be published. This information may affect the creditworthiness of the client positively or negatively.
- Audit firm: Audit firms can also provide necessary information to the bank if the potential borrower’s financial statements were audited by that auditor.
- Other bank’s report: Banks may collect information from other banks with which the potential borrower maintained transactions earlier. From these previous banks of a potential borrower, and the bank can get information regarding the track record of the loan repayment practice of the borrower
- Trade Journal: This is another source of credit information. Important information about selected firms/companies is regularly published. Banks may check such a report while analyzing the creditworthiness of a loan applicant.
- Trade Directory: Bank can also use a trade directory to collect information regarding the potential borrower. Thus the bank collects sources of credit information.
Characteristics of the Business Which Usually Gets Bank Loan
Characteristics of the Business Which Usually Gets Bank Loan; Now, I’ll discuss the characteristics of the business which usually gets bank loans. Banks prefer those business organizations that can repay both the principal amount of loan along with interest timely. Those business houses who have the potentiality to prosper, the possibility to earn more and more in the days to come and above all having goodwill and market reputation are logically preferred by the banks to be borrowers time and again. Learn more about loan characteristics. The above chart exhibits characteristics such as business houses.
Business with Less than Average profitability:
Those business organizations, which are not operating at their fullest capacity are continuously giving their best efforts to make it a success, and are very cautious in proper utilization of the loans. If they run at full capacity, these organizations are able to earn much more. As such, there is no apprehension of these organizations becoming losing concerns. As a result. bank loans are safe in these organizations. For this reason, banks preferably value these types of organizations for extending loans.
A bank can hardly make a profit if it gives loans and then after repayment of loans do not try to have them back as new borrowers. It is true that expenses for analysis and technical expertise are required in case of analyzing a new client’s fitness of getting a loan. Moreover, banks have to face the risk of wrongly selected clients in case of searching for new clients. To avoid these problems, banks generally give preference to the existing clients who have already proved their creditworthiness through their repayment transactions with the bank.
Relatively Smaller Business Unit:
Generally, small business units are not eligible to be the clients of the financial institutions and they can not sell their debt instruments easily in the money markets. For this reason, these small business firms are generally inclined to remain creditworthy business to the banks. This is why banks are also inclined to provide loans to these small business houses as it is believed that in order to prosper they will remain faithful to the bank. And these firms are most likely to take increasing doses of loans from banks by proving that they are good repayers.
Moderately Young Business Houses:
Matured business organizations keep different types of reserves, which help them not to depend largely on bank loans. But young business houses, which are still in the growing stage, may not have sufficient reserves to support their fund requirement. This is why most of the young business organizations seek bank loans Banks are also inclined to give loans to these businesses as these will take more loans as they grow larger.
The business firms, which touch the optimum level, enjoy a stable liquidity position and most likely they will not be in need of borrowings from other sources. As a result, it will not be difficult for these companies to satisfy their liquidity requirement with their own reserve. But those business firms, which are planning for modernization and expansion, will require bank loans. Sometimes, these types of firms become long-term clients of the bank and are considered as the prime customers of banks. So, the bank gives loans to that business whose characteristics are well.
Example of Acceptable and Unacceptable Loan Request of Commercial Bank
Example of Acceptable and Unacceptable Loan Request of Commercial Bank; Let’s discuss the examples of acceptable and unacceptable loan requests of commercial banks. After assessing the borrower’s creditworthiness for the loan, the bank takes the final decision of accepting or discarding loan requests. Some types of loans are restricted by the regulatory agencies while some others are logically not acceptable from recovery points of view. In the following section, we will see some acceptable and unacceptable loan requests.
Acceptable Loan Request
- Short-term working capital loan of the self-liquidating feature.
- Loans to proven and creditworthy borrowers where the source of repayment is almost certain.
- Loans to finance the carrying of commodities where the collateral is the negotiable warehouse receipt.
- Non-speculative construction loans, with commitments from reliable long-term lenders.
- Immovable property developments/ expansion loan with a clear repayment schedule.
- Various kinds of permissible consumers loan
- Exceptionally long term and revolving nature of credits to very reliable parties.
- Construction loans for housing/real estate of which ownership is indisputable.
- Loan ( without collateral) to a successful businessman with a very high reputation.
Unacceptable Loan Request
- Loans to change the ownership structure of the firm.
- Construction loans without making clear the source and schedule for repayment.
- Loans secured by the second mortgage on real estate.
- Construction loans on condominiums (ownership of more than one person) unless they are re-sold.
- Loans to a new business without a track record unless it is with adequate collateral.
- So-called “bullet” loans or non-amortizing term loans
- Loans where the source of payments is solely public or private financing, not firmly committed.
- Unsecured loans for real estate purposes.
- Loans based on unmarketable securities.
This list is far from complete, including only some types more or less generally regarded as desirable/ undesirable for commercial banks. Depending on the type, location and size of the bank, others which, might be included are term loans to more than a certain maturity; non-residential, long-term real estate loans: revolving credits; floor plan lines: loans to second mortgage companies: construction loans; unsound loans to individuals, etc. This list could be further broadened but it should be understood that some or all of these types may be highly acceptable to some banks, although inappropriate for others.
Method of Loan Pricing
Method of Loan Pricing; Now, I’ll discuss both the method of loan pricing & consideration in loan pricing. Banks are the major financial institutions, which intermediate between actual lenders and actual borrowers. For the intermediation, banks are to pay to the fund providers as ultimate lenders and charge actual borrowers. A bank acquires funds through deposits, borrowings, and equity recognizing the costs of each source and the resulting average cost of funds to the bank. The funds are allocated to assets, creating an asset mix of earning assets such as loans and non-earning assets such as banks‘ premises. The price that customers are charged for the use of an earning asset represents the sum of the costs of the banks’ funds the administrative costs e.g. salaries, compensation for nonearning assets and other costs. If pricing adequately compensates for these costs and all risks undertaken, bank value is created. Customer value is created if the price is perceived by the customer to be fair, based on the funds and service received.
The Price of Loan is the interest rate. The borrowers must pay to the bank, in addition to the amount borrowed (principal). The price/interest rate of a loan is determined by the true cost of the loan to the bank (base rate) plus profit/risk premium for the bank’s services and acceptance of risk.
The components of the true cost of a loan are:
1. Interest expense
2. Administrative cost
3. Cost of capital
These three components add-up to the bank’s base-rate of the method loan pricing. Risk is the measurable possibility of losing or not gaining value. The primary risk of making loan is repayment risk, which is the measurable possibility that a borrower will not repay the obligation as agreed.
A good lending decision is one that minimizes repayment risk. The price a borrower must pay to the bank for assessing and accepting this risk is called the risk premium. Since past performance of a sector, industry or company is the strong indicator of future performance, risk premium are generally based on the historical, quantifiable amount of losses in that category. Price of the loan (Interest Rate Charge) = Bask Risk + Risk Premium. Loan pricing is not an exact science- get adjusted by various quantitative as well as qualitative variables affecting demand for and supply of funds. There are several methods of calculating loan prices. The above diagram shows the method of loan pricing. Below you will get them in detail. So let’s know everything about the method loan pricing.
Interest-Based loan by traditional banks
|Fixed-rate||The loan is written at a fixed interest rate which is negotiated at origination. The rate remains fixed until maturity.|
|Variable-rate||The rate of interest changes basing on the minimum rate from time to time depending on the demand for and supply of funds.|
|Prime rate||Usually, the relatively low rates offered to the highly honored clients for a track record.|
|The rate for general customer||This rate is applied to general borrowers. This rate is usually higher than the prime rate.|
|Caps and Floors||For loans extended at variable rates, limits are placed on the extent to which the rate may vary. A cap is an upper limit and a floor is the lower limit.|
|Prime times||This special rate is a number of times greater than the prime rate. If the maturity of the loan is increased or decreased, this rate will also be increased or decreased in a multiple.|
|Rates on another basis||The interest rate can also be determined on the basis of the current interest rate of debt instruments or the regional index of change of interest/price. This rate is similar to prime rate except that the base is different and the rate can be a bit lower or higher than the prime rate. Examples include a regional index or other market interest rates such as the CD rate. These above items showed the method of loan pricing based on interest.|
Determining loan price without interest
|Compensating balances||Deposit balances that a lender may require to be maintained throughout the period of the loan. Balances are typically required to be maintained of average rather than at a strict minimum.|
|Fees, charges, etc.||After sanctioning credit but before disbursing the amount to the borrower, a charge is taken for this interim period. This charge helps to prevent the loan taker from making unnecessary delays in taking a loan. This apart, on special/priority cases, no interest but 3% – 5% service is charged on small loans. These above items showed the method of loan pricing based on the determination loan price.|
Pricing under Interest-free Islami mood of investment by Islami Banks
|Loan Financing by Lending||Trade-Related Modes of Financing||Investment types Modes of Financing|
|1. Service Charge based Interest-free Loans: Loans with service charge, on which the bank may recover a service charge not exceeding the proportionate cost of operations, excluding the cost of funds and provision for bad debt. The maximum service charge permissible to each bank will be determined by the Central Bank from time to time. |
2. Qard-e-Hasanah: Loans given on compassionate ground free of any interest and service charge and repayable if and when the borrower is able to repay.
|1. Mark-up: Purchase of goods by banks and their sale to clients at an appropriate mark-up price on a deferred payment basis. In case of default, there should be no markup on the mark-up.|
2. Mark-down: Purchase of trade bills and notes of credits on the basis of mark-down in price.
3. Buy-back: Purchase of moveable and immoveable property by the banks from their clients with buy-back agreements or otherwise.
4. Leasing: Rental or equipment for a fixed amount over a predetermined period to project sponsor by the banks.
5. Hire-Purchase: Rental/ price in installment over an agreed period of the project.
6. Based on Charge: Financing for development of property by the banks on the basis of the development charges, fees, commissions, etc.
|1. Musaharaka: Bank financing for investment on the basis of sharing of the profit and loss of the enterprise. |
2. Equity Participation would allow banks to purchase shares of the listed corporations.
3. Participation Term Certificates (PTCs) and Mudaraba Certificate can be issued by companies, within broad guidelines provided by the government, in terms of governing maturity, profit and loss sharing and repayment as agreed between the company and the purchaser.
4. Rent sharing will allow banks to form a partnership with their clients in the purchase of property on the basis of sharing in the rental or any other income from the property.
Consideration in Loan Pricing
Consideration in Loan Pricing; In the following lists, you will get the internal & external factors of consideration in loan pricing.
Internal factors of consideration in loan pricing
- Amount of loanable fund: Before determining the appropriate price for the loans, the bank authority at first has to reckon the amount of available loanable funds. If banks have a larger volume of surplus funds, loans may be provided even with a low-interest rate and vice versa.
- Cost of bank fund: Banks have to incur different types of expenses for utilizing the funds. If the interest payable to depositors and expenses for investment are smaller than the interest, the rate of interest may be lower.
- Administrative and transaction cost: At the time of loan pricing, banks should consider and estimate the expenses for loan processing and other administrative expenses of loan sanctioning. The interest income from the loan should be justified by taking the administrative and transaction costs into consideration.
- Overhead expenses: If the overhead expenses are larger in amount, the loan should be priced accordingly.
- Expenses for credit investigation and credit analysis: To analyze the loan application, banks need to collect accurate, relevant and complete information. This information collection is costly, no doubt. On the other hand, banks need to establish a method of evaluation and also need to pay to expert executives to analyze the information collected. The more costly the information collection is, the higher the interest rate on the loan would be logical.
- Security maintenance of expenses: Banks must determine the expenses for maintaining the small and large-sized assets kept as collateral. Banks must ponder that the expenses for the maintenance of security should be lower than the interest received on that loan. The bank should not sanction that loan if a bank finds that it will have to incur more expenses to maintain the assets to be held as security.
- Supervision and collection expenses: At the time of determining the interest to be charged on loan, a bank must consider the supervision and collection expenses. I expected interest revenue exceeds the expected supervision and collection expenses, the bank should sanction the loan and vice versa.
- Amount of risk of loan and cost of risk: A bank must consider the associated risk for the loan and the expenses due to risk. If the cost of risk to grant the loan is lower than the expected interest revenue from the loan, the loan should be granted. If the quantum & cost of risk is higher than the expected interest revenue, the loan request should be discarded.
- Amount of bad debt: Before sanctioning a loan, a commercial bank must estimate the probable noncollectable portion of the expected portion of bad debt in the total loan amount. If it is higher, the interest rate should be higher and vice versa.
- Bank customer relation: If there is a good term between the bank and the customer, the extent and demand for a loan will increase. As a result, loan collection will be easier, the relatively lower interest rate will suffice. On the other hand, if a bad relationship exists between these two parties, the amount of bad debt will file up, which will increase the loan expenses abnormally and a higher rate of interest needs to be charged.
- Earning possibility from the alternative use of fund: Banks must determine the opportunity cost of using the fund elsewhere. Banks must compare the amount of return from any other alternative investment with the return from the loan amount. After considering this, banks should fix the price of the loan.
- Shareholders expectation of dividend: After considering the expected dividend rate or bonus to be offered to shareholders, a bank should determine the price of the loan. This above list showed the internal factors of consideration in loan pricing.
External Factors of consideration in loan pricing
- Guidance of the government and bank regulatory agencies: If there is no intervention of government or bank regulatory authorities, the market price for a loan is determined by the interaction of the supply of loanable funds and the demand for loans. Government or bank regulatory authority can increase or decrease the limit of the market rate of the loan in order to materialize the planned economic development and to increase or decrease the money supply. So, banks must consider the direction of government and bank regulatory authorities at the time of loan pricing.
- A number of competitors and their capacity to control the loan market: A commercial bank should price its loan after consulting its (the bank’s) importance in the loan market, the extent of loanable funds of the competitor banks, and the competitor’s ability to control the market. It should be remembered that the more the market share of a bank is, the more controlling power over the market it has higher may be the rate of interest.
- Nature of loan price by competitors: If a bank sanctions loan at a higher rate and the adjacent competitor banks start to provide loans at a lower rate, loan clients may go to the competitor banks for the loan. So, a bank should determine the price of loans after considering the price offered by the competitors.
- Risk of increase and decrease of interest rate: The bank should analyze the trends of a few previous years’ behaviors of interest rate changes. The bank should also try to predict the extent of increase or decrease in the given period. Otherwise, the bank may face difficulties to achieve its established loan targets.
- Possibility of raising funds through other alternatives: If the borrowers can manage funds from the money market at a relatively lower cost, they will not go for the expensive option, i.e. taking loans from the bank. So, at the time of loan pricing, a commercial bank must consider the interest rate on alternative money market securities. This above list showed the external factors of consideration in loan pricing.
Principles of Sound Lending
Principles of Sound Lending; Now, you are going to know the principles of sound lending. Earning profit by providing loans is customary from the initial stage of the banking business until the date. The more efficiently a bank can manage long activities, the more profit-making will be possible by the bank. Even two decades ago, a major portion of a bank‘s profit would have been earned from loan activities alone. But merely, commercial banks have focused more than before on the non-loan activities and render many innovative services in order to raise the level of profit compared to the competitors. Banks distribute a reasonable portion of the depositors‘ money as a loan to the borrowers. Of course, the loanable funds are determined after maintaining sufficient liquidity for the depositors and also reserve as directed by the regulatory authorities. Lending money of depositors to third persons is a risky business; moreover, banks also require to pay interest to the depositors on their deposited amount. Loan activities are required to be operated not only focusing on the risk-minimizing and income augmenting approach but also focusing on some other important factors.
One of the most important ways a bank can make sure its loans meet regulatory standards and are also become profitable is to establish a loan policy. Such a policy gives the loan officers and the bank’s management specific guidelines in making individual loan decisions and in shaping the bank’s overall loan portfolio. The actual makeup of a bank’s loan portfolio should reflect its loan policy hints. Otherwise, the policy of loan will not functioning efficaciously and should be either 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 above picture, you can see some of the principles of the sound lending following which loan activities can be made proper, pragmatic and realistic.
Qualitative factors of 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 sufficient cash flow to make repayment the loan amount. Technically, the purpose must be viable and able to earn adequate profit for the borrower; else the loan recovery may be difficult.
- Safety: Safety should get prior importance while sanctioning the loan. At the time of maturity, the borrower may not be able to repay the loan amount. Banks should not sacrifice safety for profitability. Safety depends upon i) The quality of the security offered by the borrower, and ii) The repayment capacity and willingness of the borrower to repay the principal amount of loan along with interest.
- Social Responsibility: It is the bank’s social responsibility to meet up the loan demand of the locality where the bank operates its business. To increase goodwill, banks need to perform other social activities as well.
- Business ethics: Though providing the loan is the main source of the bank’s income, banks should not give loans to immoral or unethical purposes like the establishment of the brothel, illegal drug business, etc.
- Spread and risk diversification: Bunker should minimize the portfolio risk by putting its fund in a different well thought portfolio. If banks put the entire investment in one customer/sector, risk will be increased. The banker should distribute its investment in different customers/ sectors. So, if it faces any problem in any sector, it can be covered by the profit of another sector.
- National Interest: Loan activities have to 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 take into account the economic position of the country and government policy for the allocation of loans. Inflation, 5-year planning of government and tax principles dominate the loan decision of the banks.
- Recovery Possibility: The possibility of recovering the loan at the maturity period needs to be measured before sanctioning the loan to the borrower. Recovery must be ensured before sanction.
Quantitative factors of principles of sound lending
- Liquidity: Liquidity is a must for loan operation. The banker should consider the liquidity at the time of sanctioning the loan. Liquidity is necessary to meet the requirements of the depositors, disbursement of sanctioned loans, and payments to be made for recurring expenses.
- Profit and Profitability: Like other businesses, the main purpose of the bank is the maximization of profit. The difference between providing interest on the deposit and the earned interest on the loan is the main criteria for making a traditional profit. The interest rate should be cautiously determined. If the bank charges a very higher rate, clients will leave for other banks. If the rate is lower, it will be insufficient to cover the cost of the fund. So, setting the interest is not so easy task, it would be performed by efficient and active personnel past experience may play a better role.
- Business Solvency: As a profitable institution, the bank needs to maintain its long term solvency. Banks must be able to meet the demand of deposit holders. For this, a certain amount of reserve needs to be maintained by the bank. On the other hand, the amount of loan should be sufficient so that profit can be made by satisfying the demand of the borrower and meeting other expenses.
- Adequate Security: Banker should be careful in the selection of security to maintain the safety of the money sanctioned as a loan. The banker 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 the amount of near-cash item or easily convertible the better the quality of the security is. At the time of valuing the security, the banker should be more conservative.