Module-A Introduction of Loans and Advances

1. Bank Credit
2. Types of Borrowers and Loans & Advances
3. Banker-Customer Relationship
4. Credit Planning
5. Credit Policy
6. Centralized and Decentralized Credit Operations
7. Qualities of a Good Borrower
8. Features of Different Credit Products
9. Indicative Questions

1. Bank Credit:

(1.1) Definition:

The word credit is derived from the Latin word "Credo", meaning I believe. Credit is usually defined as one's
ability to buy with a promise to pay. From the banker's point of view, credit is the confidence of the lender
on the ability and willingness of the borrower to repay the debt as per schedule of repayment.

(1.2) History:

- Written loan contracts from Mesopotamia that are more than 3,000 years old showed the development
of a credit system that included the concept of interest
- It is known that the mathematics of compound interest originated in the Middle East.
- The word "finance" comes from Old French and shares a common root with the word "finish". It was
used in the 14th century, according to scholars, to imply a final settlement, and referred to
metaphorically in medieval poems which described life itself as a loan from God, and death as its final
repayment. French theologians considered lenders as "sellers of time" that acted contrary to natural
law.
- Indentured loan, used in Europe from the Middle Ages through the 1800‘s, was a mechanism that
allowed the landed gentry and rich tradesmen to borrow money for the purchase of land or a house.
- Early Italian pioneers were setting up stalls in local markets from which they would lend money. An
interest rate was applied to the loan and the borrower was expected to pay back the outstanding
monies at set intervals. The only problem with this type of loan was the wild variation in interest rates
which were set by each lender and not controlled by a central authority.

2. Types of Borrowers and Loans & Advances:

2.1. Types of Borrowers:

- Individuals: (Under retail Segments): Retail traders, Micro, Small and Medium Enterprises, Farmers,
Agricultural, Consumers, Home loan, Credit Card etc.
- Proprietorship Firms.
- Partnership Firms.
- Private Limited Companies.
- Public Limited Companies.
- Large Corporates.
 - Government Entities. (SOEs).

2.2. Types of Credit Facility:

Commercial banks make loans and advances in different forms. All types of credit facilities can be broadly
classified into two groups:

 Funded credit
 Loan
 Cash Credit
o Cash Credit Pledge
o Cash Credit Hypothecation
 Overdraft
 Bill Purchase and Discount
 Others
o Consumer Credit
o SME Credit
o Syndicated Loan
o Lease Financing
 Non-funded credit
 Letter of Credit
 Bank Guarantee
o Bid Bond
o Performance Bond
o Deferred /Payment Guarantee
o Custom and Excise Guarantee

Funded Credit:

Any type of credit facility, which involve direct outflow of bank fund is termed as funded credit facility.
Funded credit facilities may be classified into four major types:

(i) Loan: When credit facilities are made in a lump sum which is repayable either in fixed monthly
installments or in lump sum. It is allowed for a specified purpose to those parties who have either fixed
source of income or who desire to pay it in lump sum. The loans are granted for short, medium, and long
period. Short-term loans are usually granted to meet the working capital requirement of the borrower.
Medium-term loans are repayable over a period of 2 to 5 years and are granted for the acquisition of fixed
cost or business expansion such as expansion/construction/renovation of factory, purchase and installation
of capital machinery etc. and also durable goods like vehicles, equipment. Long-term loans are generally
termed as ―”Term loan”. Bank generally extends term loans for a period of five years and above for meeting
the requirement of capital investment.

(ii) Cash Credit: Cash credit is the favorite mode of borrowing by traders, industrialists, agriculturalists etc.
for meeting their working capital requirement. There are two types of cash credit:

 Cash Credit Pledge: This type of facility is provided against pledge of goods, products, merchandise
which remain in the godown under the possession of the bank with effective control but ownership
remains with the borrower.
 Cash Credit Hypothecation: Cash Credit is sometimes allowed against hypothecation of goods. It is
called cash credit hypothecation. For example, in a manufacturing company whose stocks of raw
materials and manufactured goods constantly fluctuate, it is difficult for the bankers to control such
 changes. In case of hypothecation both ownership and possession remain with the borrower but for
the hypothecation agreement, bank can take possession of the goods if the borrower defaults.

(iii) Overdraft: The overdraft is a kind of advance allowed on a current account operated upon by cheques.
The customer may be sanctioned with a certain limit upon which he can overdraw i.e. withdraw his current
account beyond his/her deposited amount (but not exceeding certain limit) within a stipulated period.

(iv) Bill Purchase and Discount: Discounting and Purchasing of bill of exchange is another way of employing
the banks fund. Bank allows advances to the clients by purchasing or discounting export bills. In this case
bank becomes the purchaser or owner of the bill, which is treated as security for advance. In case of
purchase of bill, the charges are less because the bank can collect the payment immediately.

Other Important Funded Facilities are:

 Consumer Credit
 SME Credit
 Syndicated Loan
 Lease Financing

Non-funded Credit Facilities:

Non-funded credit facilities do not require fund involvement directly. Though these types of credit facilities
are primarily non-funded in nature but at times it may turn into funded facilities. As such liabilities against
these types of credit facilities are termed as ―”contingent liability”. The major non-funded facilities are:

(i) Letter of Credit: A letter of credit is issued at the request of the client (the buyer) guaranteeing the
payment to the beneficiary (the seller) against shipment of goods.

(ii) Bank Guarantee: A bank guarantee is a promise by a financial institution to meet the liabilities of a
business or individual if they don't fulfill their obligations in a contractual transaction. Different types of Bank
Guarantee are:

 Bid Bond: One kind of bank guarantee issued by the bank on behalf of its clients (Mostly contractor)
to enable him to submit his bid in a tender.
 Performance Bond: A bond or guarantee issued by a bank on behalf of the client guaranteeing that if
the client not will perform as per the contract, the bank will compensate the loss of behalf of its
customer.
 Deferred /Payment Guarantee: Importer of capital goods like plant, equipment may find it difficult
to pay the full price of the goods immediately on their receipt. Therefore the supplier of the capital
goods extends deferred payment credit terms. Deferred payments guarantee issued by a well-
known bank is one of the acceptable securities to the suppliers by the buyer.
 Custom and Excise Guarantee: This guarantee is issued by the bank on behalf of their clients in favor
of the custom authority to make payment on account of their custom duties/excise duties on
imported goods or export of commodities on future date.
(3) Banker-Customer Relationship

The person doing the banking business is called a banker and the person who is connected with the bank,
either depositing his money or taking a loan from the bank is called a bank customer.

This relationship falls under two broad categories, namely: (i) general relationship; and (ii) special
relationship.

3.1. General relationship:

(i) Debtor and When a banker receives deposits from a customer, he is technically said to borrow
Creditor: money from the customer. So, he is acting as a debtor who is bound to return the
money on demand to his creditor namely his customer. But in the cases of a loan,
cash credit and overdraft, the banker becomes a creditor and the customer
assumes the role of a debtor.
(ii) Principal When the banker collects cheques, bills, dividend warrants, pays insurance
and Agent: premium, subscriptions etc. on behalf of his customer then the agent – principal
relationship exists between a banker and his customer.
(iii) Trustee and When a cheque is given for collection, till the proceeds are collected, he holds the
Beneficiary: cheque as a trustee and customer is a beneficiary.
(iv) Bailor and A banker becomes a bailee when he receives gold ornaments and important
Bailee: documents for safe custody.
(v) Lessor and A banker become a lessor when he allows a safe deposit locker.
lessee:

3.2. Special Relationship with Customer/Obligation of Banker:

The special features of this relationship, as a note above, impose the following additional obligations on the
banker.

 The obligation to honour the Check/Cheques

 According to section 31 of the negotiable instruments. Act 1881, the banker is bound to honour his
customer‘s check/cheque provided by following conditions are fulfilled:
- Availability of sufficient funds of the customer.
- The correctness of the check/cheque.
- Proper presentation of the check/cheque.
- A reasonable time for collection.
- Proper drawing of the check/cheque
 The obligation to maintain the secrecy of the customer accounts

(4) Credit Planning: