CHAPTER - IV

CREDIT MANAGEMENT IN COMMERCIAL BANKS

Lending is considered as one of the principal functions of commercial

b a n k s not only because of their social obligation to cater to the credit

needs of different sections of the community but also d u e to the most

profitable activity of the financial institution. After having a portion of

deposits in the c a s h reserve and highly liquid assets, a banker h a s to

deploy the remaining funds in profitable outlets so that he may be able to

pay interest on deposits, salary to the staff, meet other establishment

expenses, built u p reserves, and to pay dividend to the shareholders.

That's why b a n k loans account for a major portion of residual funds of a

commercial bank.

4.1 Characteristics of Commercial Bank Credits

Some of the most important characteristics of loans in India are

given below:-

1. In India, since nationalization b a n k s have shown keen interest in

making advances to the agriculture sector even then the bulk of

the b a n k loans are provided to trade and industries. This is

because of the relatively greater credit risks and inability of

agriculturists to furnish good security.

2. Nearly three-fourth of bank loans in our country is provided for a

period of less than one year because of the high liquidity of such

loans. The short-term loans are given to finance the seasonal

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 needs of the businessmen for increasing the current assets and for

expanding production.

3. A highly profitable firm depends less on b a n k loans to finance

expansion or current needs because it h a s sufficient earnings to do

so. The less profitable concerns need b a n k support which can help

them to tide over the financial difficulties caused by the shortage of

liquid funds. It suggests that bankers should be very careful while

granting loans to firms and should take all protective steps to

minimize their risk.

4. Another characteristic of b a n k borrowers is that smaller firms and

young concerns depend more on b a n k loans to finance their needs

because of their limited access to other sources of finance. As a

matter of fact, bank shows less interest in making advances to

such firms.

4.2 Principles of Sound Bank Lending

The most profitable business of the commercial b a n k is lending; but

at the same time, it is highly risky. Loans are always accompanied by the

credit risk arising out of the borrower's default in repaying the money.

Therefore, a lending institution should manage its loan b u s i n e s s in a

profitable and safe manner. In considering a loan proposal, banker

should bear in mind certain general principles of lending and should

take all necessary precautions to minimize the risk associated with the

grant of a loan. These principles are discussed as under:

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4.2.1 Safety

The safety of fund is the most important guiding principle of a banker.

They should ensure that the lending out fund is safe. Every care should

be taken to ensure that a loan to a particular borrower does not involve

any avoidable risk of non-payment and should always take only a

calculated risk. That is why he always insists u p o n collateral's margins

and guarantees in addition to the personal promise of the borrower.

4 . 2 . 2 Liquidity

Liquidity signifies the readiness with which the b a n k can convert its

assets into cash with no or insignificant loss. Since a major part of

commercial b a n k liabilities is payable either on d e m a n d or after a short

notice, the banker should ensure the liquidity of loans. Loans should be

provided against the security of highly convertible a s s e t s so that in the

event of borrower's defaults in repaying, these might be readily converted

into cash.

4 . 2 . 3 Diversification of Risks

Diversification implies dispersal of funds over a large n u m b e r of

borrowers and borrowing firms situated in different p a r t s of the country.

Banker should avoid concentrating the funds in a few customers. He

should diffuse lending and offer advances to different firms belonging to

different industries which are situated over different geographical areas,

so that he may not be badly mauled by the failure of one industry or a

few big borrowers. The maturity diversification is another important form

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of diversification because banker may get certain a m o u n t of loans

mature at regular intervals and are utilized to meet the d e m a n d s of other

customers.

4 . 2 . 4 Profitability

Commercial b a n k s m u s t make sufficient income to pay interest, meet

establishment charges, income for future, and to pay dividends to

owners. Inter-bank competition, inter-bank agreements and b a n k rates

make the principle of profitability as most important in loan

management. A banker should avoid making profit at the expense of the

liquidity a n d safety of his capital. Within the limits of liquidity and safety,

and the national policies as laid down by the government and the Central

Bank, a banker should strive for accomplishing the profitability objective.

4.2.5 Purpose

It is well supposed that the purpose for the loan proposed is itself a

guarantee of its repayment. Safety and liquidity of loan depends on the

purpose of its use, therefore, the banker should inquire properly into the

purpose for which the loan is taken. The loan utilized for productive

purpose would generate additional income for the borrower to enable him

to repay it.

A banker should, therefore, avoid making loans for wasteful

expenditure on social functions and''speculative transactions. It is well

known fact that loan borrowed for a productive purpose h a s often been

used for speculative purposes. Therefore, the lending commercial bank

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should take follow-up steps to see that the e n d - u s e of loan is not for a

purpose other t h a n the one for which it was given.

4.3 Formulation of Credit Policy

A b a n k can not afford to lend the funds to its depositors a n d owners

indiscriminately to meet the social obligations of diverse credit needs of

different sections of the community. A clear-cut a n d definite credit policy

which provides a direction to the use of funds controls the size a n d

make-up of the loan portfolio, and influences the credit decisions of the

bank. The banker will find it easy to reach the goals of the b a n k a n d

serve the public concurrently with a systematic loan policy. A loan policy

is, therefore, a necessity for a bank. In deciding the loan policies, the

policy formulators m u s t be very cautious, because the lending activity of

the b a n k affects both the b a n k and public at large. They should consider

all the factors which are likely to influence the loan policies, a n d work

out their policies accordingly.

4.4 Factors Influencing Credit Policy

Some of the most important factors which m u s t be considered while

determining the loan policies of a b a n k are as under:

4.4.1 Capital Position

The capital position of a bank serves as a protective factor against

losses for depositors and guarantees funds for the creditors. A b a n k with

a strong capital position can a s s u m e more credit risks thaji one with a

weak capital position.

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4.4.2 Earning Requirement

Profit making is one of the principal objectives of a commercial

bank. Some b a n k s may be in a position to emphasize the importance of

income, while other may lay stress on liquidity. Earnings receive a

greater e m p h a s i s in the loan policy of a bank, it m e a n s that it would

include securities which carry shorter maturity periods and possess

relatively less risk in its investment account.

4.4.3 Deposit Variability

B a n k s which experienced irregular movements in their deposits

will have to follow a conservative lending policy as they cannot afford to

incur u n d u e risk by extending their term-lending facilities. The b a n k s ,

whose deposits have shown a rising tendency in the past, and which

expect the rising trend to persist in future, can also be liberal in their

loan policy.

4.4.4 Position of Local and National Economy

The banker should keep in mind the economic conditions that

prevail in the area served by the bank, before formulating the lending

policy. A b a n k operating in an area which is subject to seasonal and

cyclical fluctuations and if the national economy is likely to recede in the

future can ill afford to adopt a liberal policy because that would entail

the hazards of illiquidity. But in a stable economy or if the economic

conditions of the country are expected to improve, b a n k s may liberalize

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their lending policies and accommodate those borrowers who were

hitherto refused banking facilities because of a stiff credit policy.

4.4.5 Monetary Policy

Monetary policy of the central banking authorities goes a long way

in determining the lending policy of a commercial bank. The central b a n k

influences the lending policy of b a n k s by bringing about variation in the

minimum reserve requirement and the net liquidity ratio.

4.4.6 Ability and Experience of Loan Officers

The management of a bank should consider the skill and

competence of its loan officers while laying down a loan policy because

loan officers of a bank can play a significant role in the execution of its

loan policies.

4.4.7 Competitive Position

In formulating a loan policy, the m a n a g e m e n t should have

consideration for the competitive position of the b a n k with the other

institutions operating in the area.

4.4.8 Credit Needs of the Operational Area

The credit needs of the area served by the b a n k would also

influence its loan policy. A bank is supposed to meet the loan demands

of all the local borrowers and if this cannot be done, there will be

injustice by the financial institutions existing in t h a t region.

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4.5 Contents of Credit Policy

A b a n k m u s t have a definite and broad-based loan policy which

includes all the important dimensions of its lending business so that

credit officers may not face any problem in evaluating the credit

worthiness of the loan applicants and in taking credit decisions. In the

following p a r a g r a p h s an attempt h a s been made to discuss the main

characteristics of a loan policy with respect to some aspects of guidelines

like loan portfolio, compensation, security, maturity etc.

4.5.1 Size of Loan Account

The primary social and business excuse for the commercial

banking system is its ability to supply credit to the community. A

commercial b a n k should lend as long as it is possible to do so prudently.

An intelligent loan policy m u s t spell out clearly the a m o u n t of the total

advances t h a t a b a n k would sanction and a due consideration of various

factors like Banking Companies Act, RBI guidelines and resource

position of the bank m u s t keep in mind while formulating bank credit

policy.

4.5.2 Credit for Infrastructure

In view of the natural importance attached to infrastructural

development, operational guidelines made a commercial b a n k free to

sanction term loans for technically feasible, financially viable and

bankable projects undertaken by both public and private sector

undertakings.

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4.5.3 Composition of Loan Portfolio

In an attempt to minimize the credit risks, the b a n k should clearly

mention in its loan portfolio about the various broad categories of

borrowers among which the bank's advances will be diffused, specifying

the proportion of the loan for each such category.

4.5.4 Acceptable Security

While determining the policy regarding the security aspect of a

bank loan, the government policy as well a s the credit policy of the RBI

should also be kept in view and the management should see to it that the

security requirements do not violate statutory provisions laid by RBI and

banking regulation acts.

4.5.5 Lending Criteria

In order to minimise the risk in lending, a b a n k should m a k e loans

only to deserving parties whose credit character, capacity a n d integrity

are within approach. The criteria of evaluating credit character and

capacity to generate income should be set forth in it in the policy

statement.

4.5.6 Loan Maturity

One of the most constructive characteristics of a good loan policy

is to make a loan for a period after which it may be called back in times

to satisfy the liquidity needs of the bank and e n s u r e that it is not

exposed to risk. Minimum period of loans and spread over various

maturities subject to roll-over would now be decided by b a n k s and they

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could invest short-term or temporary s u r p l u s of borrowers in money

market i n s t r u m e n t s .

4.5.7 Compensating Balance

The compensating balance is a protective device to save the bank

from the risk of default. The policy statement on the compensating

balance should include a clear cut statement on the m a n n e r of

computing the compensatory balance, the type of borrowers to whom the

compensating requirement would apply, and the specific percentages of

the loans that different borrowers would be required to hold a s deposits

in the bank.

4.5.8 Limitations on Lending Authority

A large-scale commercial bank, with a big credit organization

consisting of a n u m b e r of loan officers, should specifically determine the

loan authority of different officers; otherwise there may be overlapping

and duplication of efforts, resulting in considerable wastage.

4.5.9 Loan Territory

The loan policy statement of a commercial b a n k m u s t include the

regions or certain areas to be served by the lending operations of the

bank. This will save the time and efforts of the credit department which

will, in that case, know from whom to receive a loan application.

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4.5.10 Consortium Lending

On the basis of the suggestions of the RBI, a commercial bank also

do consortium fmancing, i.e., where one b a n k takes on the liability for a

minimum n u m b e r of years while the second b a n k steps in for the

remaining tenure for the rest of the liability. The consortiurn could

include more than two b a n k s depending on the size of the project.

4.6 Evaluation of Credit Applicant

It is impossible to accomplish the overall objective of maximizing

earnings of the commercial bank while keeping an adequate a m o u n t of

liquidity, u n l e s s the creditworthiness of the applicants is evaluated to

ensure that they conform to the s t a n d a r d s prescribed by the bank. The

credit evaluation process involve following steps.

4.6.1 Credit Informations

The credit department of a commercial bank gathers the requisite

information from different sources on which customer evaluation m u s t

necessarily be based. Two important factors, i.e., cost and time, should

be kept in mind while searching for credit information. Commercial bank

can gather information on the creditworthiness by the interview and

financial statements made by the applicant. The lending officer may also

get information about the customer's repaying habits from the bank's

own record, if the applicant h a p p e n s to be the b a n k ' s customer. Reports

on b u s i n e s s firms, especially the larger ones, can be obtained form

credit- rating agencies, bazaar reports, reports from other banks.

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journals, periodicals, newspapers, income-tax statements, sales-tax

returns, government gazettes, revenue and municipal records.

4.6.2 Credit Analysis

After gathering the credit information on the potential customer,

the lending officer analyses it to evaluate the creditworthiness of the

applicant a n d to determine whether he meets the requirements of

prefixed n o r m s or not. Credit analysis involves the credit investigation of

a customer to determine the degree of risk associated with the loan. The

capacity of the applicant to borrow and his ability and willingness to

repay the debt in accordance with the terms of the loan agreement m u s t

be studied. A n u m b e r of tools like ratio analysis, cash flow projections,

funds-flow statement, and credit scoring have been developed with which

a banker can evaluate the character, capacity, capital, collateral and

conditions of an applicant.

4.6.3 Credit Decision

After determining the creditworthiness of the applicant, the lending

officer h a s to decide whether the credit facilities should be provided to

him or not. The creditworthiness of the applicant should be matched

against the credit s t a n d a r d s se<^ out in the loan policy. If the applicant is

found above or upto the standards, the loan should be made to him and

if he does not satisfy the standard of acceptability he may be told of the

bank's helplessness in view of its loan policy. The applicant m.ay be

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asked to approach other existing financial institutions of the area for

assistance.

4.7 Supervision of Loans

To e n s u r e the end-use of the loan, it is necessary for the b a n k to

keep track of the loans outstanding. It should keep in touch with the

borrowers during the life of the loan. The supervision of the loan is the

responsibility of more than one department of the bank. The credit

department regularly obtains the financial reports of customer indebted

to the b a n k and analyses them to a s s e s s the progress made by the

customer. Usually, the outstanding loans are supervised by inspection,

keeping track of the deposit balance, checking with other creditors and

obtaining half-yearly and yearly financial and budgetary reports. If the

reports of the performance of the borrower are found unsatisfactory, the

intelligent banker can plan a sort of economic retreat which, in the long

run, works to the advantage of the borrower as well a s the lending

commercial bank.

4.8 Organization of Bank Lending

The credit policy is usually formulated by the Board of Directors,

and its implementation is carried out by the loan committee and loan

specialists because in most of the b a n k s all the directors do not attend to

the day-to-day lending activities of the bank. They constitute a separate

lending body, known as the credit department, to implement the loan

policies which they formulate.

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 The credit department of a bank performs the following functions:-

(1) It receives loan applications.

(2) It collect credit information about the applicants from different

sources, conduct interviews with the applicants, and verifies the

accuracy of the information given by them in the application.

(3) It investigates the creditworthiness of applicants by msiking u s e of

n u m e r o u s tools of credit analysis.

(4) After granting loan, it monitor loans by visiting the borrowers,

keeping a constant watch on their deposit balances, obtaining

financial and other reports and calling the attention of the

borrowers to their unsatisfactory performances.

(5) It maintains records of credit information and revises them

constantly so that bank officers may come to know the s t a t u s of

their accounts.

(6) It furnishes credit information to other b a n k s and creditors who

ask about it.

The organizational set-up of the loan function in a b a n k would

depend upon a n u m b e r of factors, including the size of the bank, the

magnitude of the loan portfolio and its composition, and attitude of the

Board of Directors, the extent of the authority delegated. In a small bank,

two or three officers perform all the necessary credit functions, and the

routine functions of the credit department are performed by a clerk.

There is a little or no specialization and each officer involved in credit

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function is responsible for securing the credit information that is

necessary a n d for nniaintaining his own credit files. In the larger banks,

the loan function is highly departmentalized, and there is a considerable

a m o u n t of specialization of the lending activities. In such branches, there

may be a good deal of specialization in lending work. For expeditious

disposal on credit requests, it is desirable to delegate more powers to

branch or regional managers.

Borrowers, particularly those requesting for a small a m o u n t of loan,

cannot be expected to wait for a long time for credit decisions. Moreover,

the personal touch or sympathetic attitude with the borrowers m u s t be

maintained, which is very necessary for the development of the banking

business.

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