Not like common form of businesses banks deals in ‘money’. It accept deposits from public at low cost and lend/invest that money back to public at higher cost. Traditionally, loans and advances account for a larger share of use of funds by the banks. As such a significant portion of bank’s income comes in the form of interest from loans and advances. In the view of this efficiency of the lending function is very important for the banks. Banks also undertake investments to earn interest and other incomes. These two activities (accepting deposit and Lending/investing money) are the core of the whole banking business. Difference between average interest rate of landing and average interest rate of accepting deposit is called ‘Net Interest Margin’. If object of bank’s business is to maximize Net Interest Margin then why banks not lend/invest money at the highest rate available in the market. This is because while lending banks have to optimize its portfolio considering risk involved and return available, thus it becomes a balancing act and not one dimensional decision. There are some fundamentals principals of banking which are cardinal to seek direction at the time of landing. A holistic approach is needed to find a tradeoff between risk and return considering following principals while lending:-
I. Safety :– The most important of these principal is of safety of funds landed. If an advance is repaid as per the agreed terms it is called safe. This repayment is depended on not just repayment capacity but is equally depended on willingness to repay. Firstly, repayment capacity is normally assessed from the cash flows of the business and DSCR plays an important role while appraising a loan proposal. But here it is to be emphasized that mere calculation of is not assure repayment capacity of the borrower because most of the times figures are fabricated. In small businesses Income Tax returns are full of imaginary figures it be profit or sales or expenditures or purchase. Corroborative evidence must always be sought from the loan applicant to substantiate these figures like GST returns, summary of cash flow etc. Same is the case with large businesses here we find appraisal more difficult because figures are manipulated by passing accounting entries which are difficult to trace but group transactions and dealing with directors and their relatives must always be considered with care. Next come the willingness of the loan applicant to repay the loan, this is difficult to assess. When an applicant has a low CIBIL/CRIF score or has written off / settled account it is normally presumed that his intention is susceptible. Sometimes intention of the applicant is also deduced from the personal interview or business reports or credit reports etc.
II. Liquidity:-The second most important aspect in lending is liquidity of the Loan portfolio. Short terms loans are normally less expensive then long term loans and different MCLR rates are announced for loans of different tenures. Commercial banks are essentially short term lenders as they repay the deposits as and when they mature or demanded. A substantial portion of deposits are in the form of savings and current accounts wherein the depositors can withdraw the money any time. There has to be a matching of repayment obligations arising at different times with cash flow arising from loan installments/borrowings/cash flow from other heads. Asset Liability Maanagement is an important function of a bank aimed at ensuring that the bank does not face a liquidity crisis. Reserve Bank of India requires banks to monitor their structural liquidity on a daily basis and submit a statement to the RBI once in a month. The statement monitors liquidity mis match at the near end of 1 day, 2-7,8-14, 15-29 and 30 days -3 months intervals The mismatch in the interval and cumulative mismatch are calculated and position monitored for ensuring dynamic liquidity.
III. Profitability:-Last but not the least this principal is also equally important while taking decision as banker. Commercial banks are for profit organizations. For lending activity to be profitable pricing of advance becomes a very important exercise. Pricing is nothing but the rate of interest charged for the loan account. Marginal Cost of Lending/ Bank’s Float Rate (Earlier Base Rate) is a rate at which at least banks should charge from borrower (Being reflection of Cost of funds of the Bank). A premium is normally added to these rates considering various risks associated with the advances. Normally we understand that a customer with better credit rating is charged less as compared to borrower with inferior rating.
Lending Balancing Act (Risks and Return)– Various risks in lending are as follows :- Credit risk is the risk that arises from the possibility of non-payment of loans by the borrowers. Although credit risk is largely defined as risk of not receiving payments, banks also include the risk of delayed payments within this category.
Operational Risks – Operational risk occurs as the result of a failed business processes in the bank’s day to day activities. Examples of operational risk would include payments credited to the wrong account or executing an incorrect order while dealing in the markets.
Earnings at risk – The amount of change in net income due to changes in interest rates over a specified period. It helps investors and risk professionals understand the impact that a change in interest rates can make on a company’s financial position and cash flow.
These are the risk which have to be considered at the time of taking decision of lending and a balance between these risks and return offered by individual lending opportunity has to be established to arrive at an optimum loan portfolio.
Autjhor: Rahul Sharma | Senior Manager (Credit) | Johari Bazar, Jaipur