Lending policy and appraisal norms by banks are decided by the Reserve Bank of India. Banks determine their lending policies on the basis of Reserve Bank of India circulars/instructions and government policies.
To lend, banks depend largely on deposits from the public. Banks act as custodians 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.
(1) 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.
(2) Liquidity
To maintain liquidity, banks have to ensure that money lent out by them is not locked up for a 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-à-vis depositors.
(3) Profitability
To remain viable, a bank must earn an adequate profit on its investment. This calls for an 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.
(4) Risk diversification
To mitigate risk, banks should lend to a diversified customer base. Diversification should be in terms of geographic location, nature of the 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.
Based on the general principles of lending stated above, the Lending Policy Committee (LPC) of individual banks prepares the basic Lending 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 Lending management including standards for presentation of Lending proposals, financial covenants, rating standards and benchmarks, a delegation of Lending approving powers, prudential limits on large Lending 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 Lending-deposit ratio
– Targeted portfolio mix
– Hurdle ratings
– Loan pricing
– Collateral security
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