By Sudhakar Atre:
In good old days only few rich business persons use to borrow from banks. After nationalisation of banks and more particularly after liberalisation of economy in 1991, taking loans from banks gained momentum. But after demonetisation and with the introduction of financial inclusion programmes like ‘Jandhan’ it became a part of life of the general public. Hence strengthening of banking literacy in the country is the need of the hour. It is true that there is a reasonable awareness about deposit and services of banks but it must be accepted that there is an alarming lack of awareness about concept of bank loans and advances in the public mind.
Unfortunately very little effort has been made by the stake holders in this regard which has caused enormous damage to the credit culture and development of the healthy banking in the country. This is an attempt to explain the basics concepts of bank loans and advances to general public. “Banking” means accepting deposits from public for the purpose of lending and investment. Banks mobilises deposits from large number of depositors and lend those funds to needy / worthy borrowers and / or invests in appropriate avenue. However there are certain regulations which does not allow banks to lend/ invest the entire amount of deposits mobilised by banks.
Reserve Bank of India (RBI) prescribes a certain percentage of deposit is to be kept with RBI which is called Cash Reserve Ratio (CRR). At present this ratio is at 4 per cent. In addition to this banks have to invest a certain percentage of its deposit in approved securities. This is called as Statutory Liquidity Ration (SLR) which is at present 19 per cent of deposits. Bank also has to maintain some cash/liquidity say 1 per cent of its funds for its day to day operations.
Thus out of Rs 100 mobilised as deposits, after providing for CRR and SLR and cash in hand bank can lend and invest maximum Rs 76 only. This is required for maintaining a cushion as depositors may require their funds anytime and all the borrowers may not be in a position to return the loans taken by them at the time of such an emergency. Even though the banks may have sufficient deposit available for lending but there is another rider attached to it which is called as Capital Adequacy Ratio (CAR). In simple terms every bank must have prescribed capital in percentage terms for lending. The Basel III norms stipulated a capital to risk weighted assets of 8 per cent.
However, as per RBI norms, Indian scheduled commercial banks are required to maintain a CAR of 9 per cent while Indian public sector banks are emphasized to maintain a CAR of 12 per cent. It’s a more complex issue as loans (assets) are given some risk weight to calculate this ratio hence it is now called as capital to risk-weighted assets ratio (CRAR). Suffice to say that if RBI wants to promote credit to any particular sector the risk weight will be zero and if it wants to discourage credit to any particular sector the risk weight will be higher. For the sake of illustration if a bank wants to lend Rs 100, it must have its own capital of Rs 9.
Banks undertake lending to a variety of industries and purposes ranging from agriculture to manufacturing, retail to whole sale and lending in local currency to lending in foreign exchange. In our country RBI prescribes the allotment of sectoral deployment of credit for achieving balanced growth. Out of the total advances 40 per cent of the loans are to be given to priority sector which includes (i) Agriculture (ii) Micro, Small and Medium Enterprises (iii) Export Credit (iv) Education (v) Housing (vi) Social Infrastructure (vii) Renewable Energy (viii) Others. And for each category percentage of lending is also prescribed. So banks have to manage their overall loans and advances within this framework. The major portion of income of bank comes from interest on loans given by it.
The difference between the average interest rate paid on its deposits/borrowings and the average interest rate charged on its lending determines bank’s profitability. The rates of interest (ROI) on loans are market and risk driven. If bank charges very high ROI, good borrowers may not take loans from it and if it charges very low interest its profitability will be at stake. So it has to maintain a very judicious ROI linked to risk of the loan. It is very difficult for a bank to choose a good borrower/business who will repay the money in time. The bank generally applies certain yardsticks before sanctioning a loan. The most important is the character of the borrower.
This is arrived by studying his credit history, his business acumen, financial discipline etc. Bank also sees that the prospective borrower has basic knowledge or the experience he is venturing into. Banks also ensure that the activity is legal and permissible as per local laws. But the most important is the economic viability of the business so that it will generate sufficient income to repay as stipulated and agreed up on and on due dates. The most talked about parameter is the security of the loan. It has two ingredients. The assets acquired out of bank loan are called as primary security and the assets which bank takes as a buffer if the business fails and it has to recover money from realising the assets out of principal activity are called as collateral security. (The author is a freelance writer on banking. He may be contacted on [email protected])