INTRODUCTION

Banking, today, covers a large number of activities. With globalization, banking is not
restricted to receiving deposits for the purposes of lending. Banks offer various facilities to its
customers. They provide lockers, safe deposit vaults, finance for margin trading, collecting
dues and charges for and on behalf of the Government, local authority, MTNL, BEST,
MSEB, etc.1 It is reality that the Banks' main source of funds is deposits of its customers
which are intended to be repaid on demand or after specified time. Thus, the banks deploy the
deposited money as investments or loan and advances which in turn will generate interest, the
major Source of income for the Banks. Additionally, by granting loans and advances, the
banks contribute a lot for economic development of the society as whole and in particular to
the industrial and agriculture sectors. But at the same time, it is worthwhile to mention that
while deploying the deposits of customers in loans and advances, the banks need to play very
cautious role as non-repayment by the borrowers may increase the problems of the Banks, So,
the banks ensure to have an effective and proper credit monitoring system at pre-sanction and
post- sanction levels.
Money lending is important task that is performed in the society from ancient times. Initially
it was performed separately and also become a means for exploitations. But after the
development it is mostly regulated by law.
Money lending is now one of the primary functions of Banks. The banks not only accept
deposits rather they lend money too, which are obtained by deposits , to the person with
interest. This provides a channel through which the individual savings can be lent to the
commerce and industry. The banks lend money in various forms which may be secured or
unsecured. The popular forms of lending are loans and advances.

LOANS AND ADVANCES: CONCEPT

The terms 'loans' and 'advances' are used interchangeably but both the terms are different.
The term 'loan' refers to a debt provided to a person, known as borrower, by a financial
institution for a particular period with the condition of repayment of the loaned money to the
concerned financial institution supplemented by the interest.

1
CIT v. Ahmednagar Distt. Central Co-operative Bank Ltd, (2003) 132 TAXMAN 226 Bom
A loan of money is a contract by which one delivers a sum of money to another, and the
latter agrees to return at a future time a sum equivalent to that which he borrowed. 2 A
contract of loan of money is a contact whereby one person s or agrees to lend a sum of money
to another, in consideration of a promise express or implied to repay that sum on demand, or
at a fixed or determinable future time, or conditionally upon an event which is bound to
happen, with or without interest.
Bombay High Court observed that 'in order to constitute a loan, there must be a thing loaned,
a lender, and a borrower, as well as a contract between the parties.3 In another case', Hon'ble
Bombay High Court held that if the payment is made by the lender to the borrower, then such
payment would amount to loan because the relationship of the creditor and borrower is
created transaction. In CIT v. Jamnadas Khimji Kothati 4 , it was held that if there aro
transactions between two parties and as a result of such transactions one m becomes debtor to
the other, then the anmount advanced by the creditor fo the debtor will be considered as a
loan and advance.
Thus, loan may be termed as 'borrowing from the view point of borrower and from the view
point of Bank, it is 'lending. In loan, the money is disbursed to the particular borrower for a
specific purpose and specific period repayable in installments.
In Chitar Singh v. Roshan Singh 5 ,Collister, J., ruled that the unpaid balance of sale
consideration couid not be regarded as a loan, whether technically or substantially.
On the other hand, the 'advance' is a 'credit facility' provided by the Bank for short-term
purposes. "The word 'advance' conveys the idea of furnishing, tendering or offering
something which may be returned in the same form. It is not synonymous with exchange for
money.’6 An advance is granted either by way of overdraft upon a current account, or by a
loan upon a separate account, or, upon a promissory note. The discounting of bills is
practically the same as making an advance upon the security of the bills.7
The price due for the articles purchased by an agriculturist cannot be regarded as an 'advance'
to him in kind.8 The sale of a half share in a motor lorry can be said to be an advance.

2
Henry Campbell Black, A Law Dictionary Containing Definitions of the Terms and Phrases of American,2nd ed.
(New Jersey: The Lawbook Exchange Ltd. 1995) at 733
3
Quoted in: Life Insurance Corporation of India v. Joint CIT, (2002) 74 TTJ Bombay 624
4
1973) 92 ITR 106 (Bom)
5
AIR 1943 All 301
6
Aziz Ahmad Khan and another v. Atthar Husain and another. AIR 1971 All 169
7
William Thomson, Dictionary of Banking: A Concise Encyclopedia of Banking Law and Practice (London: The
Waverley Book Company, Limited) at 17
8
Khincha Mal Hari Kishan Dass v, Khub Ram Munna Lal, AIR 1937 All 669
In M.D. Jindal v. CIT9, it was held that it is not necessary that in the case of loans and
advances the payment should be by cash only. Even transfer of goods may amount to advance
by a person.
In State Bank of Mysore v. CIT10, the Court held that the term "loans and advances" is not to
be restricted to merely cash, transactions between two persons but it includes all categories of
loans and advances which involves monetary transactions for which compensation is payable
for delayed payment of money due.
The loan is known as debt but advance is known as credit facility. The legal formalities are
more in loan in comparison to advance. The loan is granted for long term but advance is a
short term facility.

PRINCIPLES OF LENDING

As we know the business of lending is not free from numerous inherent risks, hence the
banks are required to have sound policies to prevent financial loss. In simple terms, the Bank
should be more cautious about the borrower before lending and there should be proper
decision on the part of the Bank.

Madras High Court in A. Kasinathan v. The Branch Manager, Canara Bank, Madurai11,
observed that the banks cannot ignore its general principles of lending. Bank is dealing with
public money entrusted by it. In any lending, Bank should carefully inquire into the
reputation and standing of the borrower and his capacity to repay and viability of the scheme,
lest, it would become a non-performing asset.

To make good loan decision, there are certain basic principles of Bank lending which may be
divided as under:

ACTIVITY LEVEL

The following principles are necessary to be applied while appraising the proposal of loans:

9
(1987) 164 ITR 28(Cal)
10
(1987) 175 ITR 607(Kar)
11
W.A.(MD) No. 1629 OF 2011 decided ON 20 April 2012
SAFETY

Banks are trustee of public money. Bank’s deposits are always payable on demand. Bank has
to maintain trust of depositor forever. As such the first and foremost principle of lending is to
ensure safety of funds lent.

By safety means that the borrower is in a position to repay the loan, along with interest.
Further, it is just not the capacity of the borrower to repay but also his willingness to repay.

Advances should be expected to come back in the normal course. The repayment of the loan
depends upon the borrower’s capacity to pay and willingness to pay. The capacity depends
upon the tangible assets of the borrower. The willingness to pay depends upon the honesty
and character of the borrower.

The banker should lend to a reliable customer who can and will repay the loan within the
prescribed period of time after generating surplus from business such that doubtful debts are
avoided. In practice, banks ensure that they adhere to this principle by taking collateral
security that is marketable, apart from primary security, which the bank can dispose off in the
event of default.

In more recent times, bankers have begun to concentrate more on the business aspect of the
borrower, i.e., the purpose and viability of the business rather than on the collaterals.

Thus, bankers have begun to treat the entire business as security and in this manner moved
away from the traditional concept of collaterals. Thus bankers must take utmost care in
ensuring that the business for which a loan is sought is a sound one, and that the borrower is a
person of integrity who is capable of carrying out his business successfully.

LIQUIDITY

The term liquidity refers to the extent of availability of funds with the banker for providing
credit to borrowers. It is to be seen that money lent is not going to be locked up for a long
time. Liquidity is the availability of bank funds on short notice. The borrower must be in a
position to repay within a reasonable time. Liquidity also signifies that the assets should be
salable without any loss.
The money should return to the bank as per the repayment schedule. This schedule that is
drawn up by the banker has to adhere to the requirement that at any point of time the banker
should possess liquidity to meet the withdrawals of the depositors.

It is to be kept in mind that various deposits have various maturities and some of it would
also be payable on demand. A bank’s inability to meet the demand of its depositors can lead
to a run on the bank which is a threat to its basic survival.

Hence the banker has to always monitor the cash flows and carry out the exercise of ensuring
liquidity with the borrower as this in turn means liquidity with the banker. Further, liquidity
would also refer to the quality of assets, which should be easily convertible into cash without
any loss of value.

Thus the concept of liquidity entails the banker to look for easy sale ability and absence of
risk of loss on sale of asset, which has been taken as collateral.

PROFITABILITY

Bank are not charitable institutions. All banks are profit-earning institutions. A banker has to
see that major portion of the assets owned by it are not only liquid but also aim at earning a
good profit. Banks receive interest on loans and advances lent, and they pay interest to their
depositors. The difference between the interest received on advances and the interest paid on
deposits constitutes a major portion of bank’s income. Besides, foreign exchange business is
also highly remunerative.

Banks further incur various expenses as any organization does. After accounting for all such
expenses and provisions, banks have to earn a reasonable amount as net profit (NIM) so that
dividends can be paid to its shareholders.
The trust and confidence level of the customer and investor will be high with a bank that has
a good track record of profits and dividend rates.
Hence it is important that whatever the business the bank engages itself with, the business be
profitable enough not just to cover its costs but to ensure generation of surplus funds or
margin.
It is prudent for the banker to consider overall profitability of the entire business that is
undertaken rather than the profitability against each component of business or service
offered.
It is also a recent practice to analyze the profitability of operations vis-à-vis particular
customers. This approach, known as the Customer Profitability Analysis (CPA), enables the
banker to decide the extent to which he can compromise on the profitability aspect so that a
competitive rate can be offered to customer.

This analysis is done when more than one service is offered by the bank and to attract more
customers. In the current context of the availability of freedom to a banker in the matter of
pricing credit and services, a very conscious and careful exercise is called for on his part in
order to strike a proper balance between the twin aims of making a desirable level of profit
and at the same time offering a competitive price for the product/service.
This is the kind of approach that is required of a banker in order to entice new customers to
his fold while retaining the existing customers. There is a direct relationship between profit
and pricing of service offered by the banker.

PURPOSE

While lending the funds, the banker enquires from the borrower the purpose for which he
seeks the loan. Banks do not grant loans for each and every purpose. A banker would not
throw away money for any purpose for which the borrower wants. The purpose should be
productive so that the money not only remains safe but also provides a definite source
repayment.
The funds lent should be put to optimum use. Loans are not to be granted for speculative and
unproductive purposes like hoarding stock or for anti-social activities, since apart from the
morality of such activities, there are also inherent risks involved with regard to the repayment
of such loans.
Loans that are meant for personal expenditure like marriage cane be refused. In some cases,
the banks grant loans for personal expenditure and for short/medium term like for education
etc.
It is however the duty of the bank to keep in mind that the other principles of lending are
adhered to, which in turn will automatically ensure that this principle is taken care of as well.
SECURITY

The security offered against the loans may consist of a large variety of items. It may be a plot
of land, building, flat, gold ornaments, insurance policies, term deposits etc. There may even
be cases where there is no security at all. Security serves as a safety valve for an unexpected
emergency. The security offered for an advance is a cushion to fall back upon in case of need.
An element of risk is always present in every advance however secured it might appear to be.

Nevertheless, the security if accepted must be adequate and readily marketable, easy to
handle and free from encumbrances. It is the duty of the banker to check the nature of the
security and assess whether it is adequate for the loan granted. Apart from the collateral, the
banker has also to consider other factors such as capital of the borrower, his character and
capacity.

Risk management through diversification

A prudent banker always tries to select the borrower very carefully and takes tangible assets
as security to safeguard his interests. While this is no doubt an adequate measure, there are
other unforeseen contingencies against which the banker has to guard himself. Further if the
bank lends large amounts to a single industry or borrower, then the default by that customer
can affect the banking industry as a whole and will affect the basic survival of the industry.

The advances should be as much broad-based as possible and must be in keeping with the
deposit structure. The advances must not be in one particular direction or to one particular
industry. Again, advances must not be granted in one area alone.

To safeguard his interest against all such risks, the banker follows the principle of
diversification of risks based on the famous maxim ‘never keep all the eggs in one basket’.
By lending funds to different sectors, a bank can save itself from the slump in some sectors
by way of prosperity in the others. Banks have to lend to a large number of industries and
borrowers so that the risk gets diversified.

INDIVIDUAL LEVEL

There should be proper authentication about the credit worthiness of the prospective
borrower. The banks judge the credit worthiness of a person on the basis of:
CHARACTER

Character denotes integrity of the borrower i.e. he should have willingness to repay the
money borrowed. The banker should investigate every aspect of the character factor and
should convince himself that despite adverse conditions, the applicant will make every effort
to discharge his debt as per terms.

He should assess the personal characteristics which include honesty, attitude, willingness and
commitment to repay debts. There is however no set guidelines to carry out such an
assessment. The characteristics are very personal in nature and in fact it may not be possible
to carry out a fool-proof analysis. The banker should nevertheless carry out this assessment
with sincerity.

CAPACITY

Capacity means the ability to employ the funds profitably according to the terms and
conditions. The capacity of the borrower has to be determined to find out his experiences in
the line in which he is working.

This includes the evaluation whether the borrower has the potential to repay the loan from his
own resources. It includes the borrower’s success in running in business or managing his cash
flows. Capacity of physical assets, plants and equipment, cash flows etc are usually taken into
account in this regard. Banks normally insist upon their prospective borrowers to submit their
financial statements in order to determine their creditworthiness. The importance of financial
statements in this regard will be dealt with in the forthcoming units.

CAPITAL

Capital denotes financial soundness. The borrower must have his own stake in the business
which creates a sense of involvement in the mind of the borrower. Capital is the financial
strength of a risk as measured by the equity or net worth of the business. The financial
strength of the borrower or his net worth is carefully studied by the banker. It represents the
amount of equity capital that a firm can liquidate for payment of debt n the eventuality of call
other means failing. The amount of the borrower’s capital in relation to debt is relatively easy
to compute. However, the valuation of underlying assets in which capital is invested is a
complex but vital exercise and has to be carried out.
CONDITION

Condition refers to the general business condition and the conditions in the particular industry
in which the borrower is engaged. The banker should exercise prudence whether the business
establishments are existent and continuing their business.

The banker has to assess the conditions in which the borrower is operating his business. A
STEP analysis may come in handy in this regard. STEP stands for Social, Technological,
Economic and Political conditions. The market potential of the product, the competitiveness
of the firm in the market, the growth prospects and other such factors influence the
borrower’s ability to repay the debt. The banker must also consider external factors that
maybe beyond the control of the firm but may nevertheless affect the business.

COLLATERAL

Collateral implies the additional securities taken to offset weaknesses that are apparent. All of
the collateral that may be made available to the bank will not make a bad loan good but it will
make good loan better. While assessing valuation of collateral securities bankers need to take
extra care by sampling survey and by examining information from land revenue office and
also enquiring people nearby. The documents of the collateral securities are to be verified
from the concerned Sub-Registered Office and other related office.

COMPLIANCE

The loan, which is to be given to the borrower, should be in accordance with the rules and
regulations as stipulated. Banker has to ensure that all the formalities are met as its absence
may cause a concern for recovery of the loan. Hence to safeguard this interest banker has to
conform to the guidelines issued by the government and regulatory authorities.

TYPES OF CREDIT FACILITIES

Advances can be broadly classified into: fund-based lending and non-fund based lending.

FUND BASED LENDING

This is a direct form of lending in which a loan with an actual cash outflow is given to the
borrower by the Bank. In most cases, such a loan is backed by primary and/or collateral
security. The loan can be to provide for financing capital goods and/or working capital
requirements.

OVERDRAFTS

Overdraft means allowing the customer to draw cheques over and above credit balance in his
account. Overdraft is normally allowed to Current Account Customers and in exceptional
case SB A/c holders are also allowed to overdraw their account. The high rate of interest is
charged but only on daily debit balance. An overdraft is repayable on demand. There are two
types of overdraft prevalent in Banks i.e.

(i) Temporary overdraft or clean overdraft

(ii) Secured overdraft.

Temporary overdrafts are allowed purely on personal credit of the party and it is for party to
meet some urgent commitments on rare occasions. Allowing a customer to draw against his
cheques sent in clearing also falls under this category. Secured overdraft is allowed up to a
certain limit against some tangible security like bank deposits, LIC policies, National Saving
Certificates, shares and other similar assets. Secured overdraft is most popular with traders
as lesser operating cost, simple application and document formalities are involved in this
facility.

CASH CREDIT ACCOUNT

Cash credit account is a running account just like a current account where debit balance in
the account up to a sanctioned limit or drawing power fixed based on stock holding
whichever is less. Sanction of Limit generally for 1 year. The limits are renewed or
enhanced/reduced based on assessment of customer’s actual requirement on the basis of
working of the unit. Customer has to submit periodic Stock statements depending on
Operating Cycle, Turnover, and Cash Budget or Projected Balance Sheet. Cash Credit facility
is offered normally against pledge (Key Cash Credit) or hypothecation of prime security such
as, book debts (receivables), stocks of raw materials, semi-finished goods and finished goods.
In some cases, customers, mainly traders find it difficult to maintain stock register and
submitting periodic stock statements. For such customers also CC facility is provided by
banks against pledge of gold jewelry, assignment of Life policies, or against security of
customer’s deposit in the same bank. When prime security is, jewels or life policies, NSC,
bank deposits, there is no need to submit periodic stock statements. In case of manufacturing
units this facility is required for purchase of raw materials, processing and converting them
into finished goods. In case of traders, the limit is allowed for purchase of goods which they
deal.

LOANS

In the loan system, the credit is given by the bank to the borrower with or without security for
definite period and purpose and the borrower is under obligations to repay, generally in
installments, the amount with interest. In this system, the borrower has to pay the interest
from the time when the loan is sanctioned and it is totally immaterial whether the loaned
money is being used or not. As a matter of right a borrower cannot claim to sanction loan.
The Bank is fully authorized to grant or refuse the loan depending upon its own cash
resources and lending policy. This system is beneficial for the banks as interest generates on
whole sanctioned amount but the documentation for loan is more comprehensive, Broadly,
the loans may be demand loan, term loan or bridge loan.

DEMAND LOANS

The demand loan is repayable on demand t the Bank. Generally, it is demanded at short
notice. It is known as a loan with no fixed duration of repayment.

TERM LOANS

The term loans are granted by the Banks to the manufacturing, trading and service sector
units to enable their manufacturing activities and their business expansion for fixed period
exceeding one year T term loans may be short (1-3 years), medium (3-5 years) and long term
(more than 5 years) loans. Chitty said that in a term loan, repayment is due at the end of it
specified period and, in the absence of any express provision or implication to the contrary,
no further demand for repayment is necessary.

BRIDGE LOANS

The RBI has authorized to the banks to grant bridge loans to companies for a period not
exceeding one year against expected equity flows/issues. Such loans should be included
within the ceiling of 40 percent of the banks' net worth as on March 31 of the previous year
prescribed for total exposure, including both fund-based and non-fund based exposure to
capital market in all forms. In this respect, it is important to note that the banks should
formulate their own internal guidelines with the approval of their Board of Directors for grant
of such loans, exercising due caution and attention to security for such loans. The banks may
also extend bridge loans against the expected proceeds of Not- Convertible Debentures,
External Commercial Borrowings, Global Depository Receipts and/or funds in the nature of
Foreign Direct Investments, provide the banks are satisfied that the borrowing company has
already made firm arrangements for raising the aforesaid resources/funds.

There are other types of loans also which may be categorized as under loan:

SECURED LOANS

Secured loans are backed by assets belonging to the borrower in order to decrease the risk
assumed by the Bank with the condition that the assets may be forfeited by the Bank if the
borrower fails to make the necessary payments. As per Sec. 2 (n) of the Banking Regulation
Act 1949 'secured loan or advance' means a loan or advance made on the security of assets
the market value of which is not at any time less than the amount of such loan or advance. In
simple terms, secured loans are those in which some guarantee of returning money is given.
Such guarantee may be some tangible assets. Secured loans are sometimes called homeowner
loans.

UNSECURED LOANS

Unlike secured loans, in unsecured loans the guarantee of an asset to repay the lent money by
the borrower is not given. Sec. 2 (n) of the Banking Regulation Act, 1949 defines 'unsecured
loan or advance' as a loan or advance not so secured. For example-personal loans, credit card
loans nd education loans etc. In unsecured loans, the Bank cannot take any asset of the
borrower In case of default in repayment by the borrower except approaching to the court.
Unsecured loans typically carry a higher interest rate than secured loans.

SHORT TERM LOANS

These loans are granted for less than one r. For example-to meet working capital
requirements.
MEDIUM TERM LOANS

Medium term loans are granted for a period ranging from 1 year to 3 years. For example-to
purchase equipments for professionals or furniture etc.

LONG TERM LOANS

These loans are granted to meet the long-term requirements. Generally, the long term loans
are granted for three years to twenty years or more. For example-loans to purchase land,
building, plant and machinery etc. But, banks do not provide long-term loans to everyone
rather these are granted to very limited extent.

COMMERCIAL LOANS

The commercial loans include loans for commercial purposes to sole proprietorships,
partnerships, corporations, and other business enterprises, whether secured or unsecured,
single-payment, or installment. In other terms, these loans are granted to different types of
business entities. For example-it may be extended to assist a company with short term
funding for basic operational functions like-meeting payroll or purchasing supplies that are
used in the production of the goods manufactured and sold y the company or it may be used
to purchase new machinery that is directly Connected to the operation of the business. The
commercial loans may be-term bans, short-term loans, lines of credit, real estate and
equipment loans, contract financing, bridge loans, leasing and asset-based loans etc.

CONSUMER LOANS

These loans are granted for financing household goods like-television, scooter, refrigerator
etc.

AGRICULTURAL LOANS

The banks provide short term loans also agriculture. These loans ore short term loans. These
loans are granted to farmers agriculture activities like buying seeds, insecticides, fertilizers
etc.
NON-FUND BASED LENDING

In this type of facility, the Bank makes no funds outlay. However, such arrangements may be
converted to fund-based advances if the client fails to fulfill the terms of his contract with the
counterparty. Such facilities are known as contingent liabilities of the bank. Facilities such as
'letters of credit' and 'guarantees' fall under the category of non-fund based credit.

Let us explain with an example how guarantees work. A company takes a term loan from
Bank A and obtains a guarantee from Bank B for its loan from Bank A, for which he pays a
fee. By issuing a bank guarantee, the guarantor bank (Bank B) undertakes to repay Bank A,
if the company fails to meet its primary responsibility of repaying Bank A.

LETTER OF CREDIT

When a buyer or importer wants to purchase goods from an unknown seller or exporter. He
can take assistance of bank in such buying or importing transactions.

Bank issues a LETTER OF CREDIT in addressed to the supplier or exporter after it, supplier
or exporter will supply the goods to such unknown buyer or importer. A signed Invoice with
Letter Of Credit is presented to the bank of buyer/importer and the payment is made to the
seller/exporter DIRECTLY by the bank.

BANK GUARANTEE

It is a guarantee issued by a banker that, in case of an occurrence or non-occurrence of a

particular event, the bank guarantees to fulfilled the loss of money as stipulated in the
contact. It may of various types like Financial Guarantees, Performance Guarantees and
Deferred Payment Guarantee.

BUYER CREDIT

It is the credit availed by an Importer from overseas lenders (i.e. Banks & Financial
Institutions) for payment against his imports. The overseas bank usually lends the Importer
based on letter of credit, bank guarantee issued by the importer bank.
SUPPLIERS CREDIT

Under such credit facility an exporter extends credit to a foreign importer to finance his
purchase. Usually the importer pays a portion of the contact value in cash and issues a
Promissory note as evidence of his obligation to pay the balance over a period of time. The
exporter thus accepts a deferred payment from the importer and may be able to obtain cash
payment by discounting or selling such promissory note created with his bank.

CREDIT PROCESS
The credit process is referred in relation to money loaned to customer and the related internal
sanctioning and monitoring activities, In simple terms, in credit process the loan sanctioning
and monitoring process is included. It involves the steps as-

Origination Approval Administration Monitoring Control

ORIGINATION
Origination is called the starting point of the credit process in which the banks identify the
following-

 Target credit markets

 Priority sectors
 Products on a portfolio basis and
 Key individual/business customers

This part starts with collection, analysis and evaluation of information about the borrower for
a thorough analysis of his creditworthiness, capacity e willingness to repay the loan. For this
purpose, the banks cautiously examine following issues-

 The borrower's current and expected financial condition.

 a borrower's ability to withstand adverse conditions or stress,
 The borrower's credit history and a positive correlation between historical and
projected repayment capacity.
 The optimal loan structure, including loan amortization, covenants, reporting
requirements - the underwriting elements.
 Collateral pledged by the borrower - amount, quality and liquidity; Bank ability to
realize the collateral under the worst case scenario. .
 Qualitative factors, such as management, the industry and the state

In simple terms, in this part the details of borrower like his age, minimum lun amount
total employment years, payment history etc. are analyzed.
APPROVAL
The Bank analyses the contents of the credit memorandum, credit investigation report and
other data available to decide whether the borrower is able be granted loan or not. In other
terms, when the credit analysis is completed and be borrower is found to be eligible for
granting loan, the bank proceeds for the next component of the credit process i.e.
preparing loan structure for its approval which preserves the strengths and protects
against identified weaknesses of the borrower. If the loan proposal is not approved, it may
be asked to modify and if it is modified, then it goes back to origination stage. If the
status of borrower is not as per bank's norms, the loan proposal is rejected which
terminates the relationship totally between Bank and the prospective borrower.

Where the loan is approved, a letter of offer and other in-house documents e prepared.
These documents are prepared in prescribed standard format of the Bank. At this stage,
the borrower is free to accept or refuse the offer. If the offer refused by customer, the
relationship between them ends and if accepted by borrower the next stage i.e.
administration starts,

ADMINISTRATION
At this stage the other formalities like security documentation is prepared. The main
objective at this level is to prepare for the facility to be drawn down. This Serves as check
and balance to ensure all conditions precedent are complied with.

MONITORING
Next , as per the norms of concerned Bank, if the loan is granted the borrower is asked to
use credited amount for the accepted/granted purposely. The Bank has to monitor
properly whether the loan is being utilized for the tended purpose or not.

CONTROL
The Bank has to keep control over the money lent to borrower with interest for
repayment. If the borrower is not returning the money, the Bank has to take proper steps
like taking recourse of legal remedies by suing principal borrower and the guarantors, if
any. However, when the lent money is repaid by the borrower, the relationship between
Bank and the borrower comes to an end in due course and any collateral security shall be
discharged in natural way.
MANAGEMENT OF NON PERFORMING ASSETS
An asset of a bank (such as a loan given by the bank) turns into a non-performing asset
(NPA) when it ceases to generate regular income such as interest etc for the bank. In other
words, when a bank which lends a loan does not get back its principal and interest on time,
the loan is said to have turned into an NPA. Definition of NPAs is given in 4.4.1. While
NPAs are a natural fall-out of undertaking banking business and hence cannot be completely
avoided, high levels of NPAs can severely erode the bank's profits, its capital and ultimately
its ability to lend further funds to potential borrowers. Similarly, at the macro level, a high
level of nonperforming assets means choking off credit to potential borrowers, thus lowering
capital formation and economic activity. So the challenge is to keep the growth of NPAs
under control. Clearly, it is important to have a robust appraisal of loans, which can reduce
the chances of loan turning into an NPA. Also, once a loan starts facing difficulties, it is
important for the bank to take remedial action.

Level of Non Performing Assets

The gross non-performing assets of the banking segment were Rs. 68, 973 crores at the end of
March 2009, and the level of net NPAs (after provisioning) was Rs.31, 424 crores. Although
they appear to be very large amounts in absolute terms, they are actually quite small in
comparison to total loans by banks. The ratio of gross non-performing loans to gross total
loans has fallen sharply over the last decade and is at 2.3 per cent as at end-March 2009.
This ratio, which is an indicator of soundness of banks, is comparable with most of the
developed countries such as France, Germany and Japan. The low level of gross NPAs as a
percent of gross loans in India is a positive indicator of the Indian banking system

CLASSIFICATION OF NON-PERFORMING ASSETS

Banks have to classify their assets as performing and non-performing in accordance with
RBI's guidelines. Under these guidelines, an asset is classified as non-performing if any
amount of interest or principal installments remains overdue for more than 90 days, in respect
of term loans. In respect of overdraft or cash credit, an asset is classified as non-performing if
the account remains out of order for a period of 90 days and in respect of bills purchased and
discounted account, if the bill remains overdue for a period of more than 90 days.

All assets do not perform uniformly. In some cases, assets perform very well and the
recovery of principal and interest happen on time, while in other cases, there may be delays in
recovery or no recovery at all because of one reason or the other. Similarly, an asset may
exhibit good quality performance at one point of time and poor performance at some other
point of time. According to the RBI guidelines, banks must classify their assets on an on-
going basis into the following four categories:

STANDARD ASSETS:
Standard assets service their interest and principal installments on time; although they
occasionally default up to a period of 90 days. Standard assets are also called performing
assets. They yield regular interest to the banks and return the due principal on time and
thereby help the banks earn profit and recycle the repaid part of the loans for further lending.
The other three categories (sub-standard assets, doubtful assets and loss assets) are NPAs and
are discussed below.

SUB-STANDARD ASSETS:
Sub-standard assets are those assets which have remained NPAs (that is, if any amount of
interest or principal installments remains overdue for more than 90 days) for a period up to 12
months.

DOUBTFUL ASSETS:
An asset becomes doubtful if it remains a sub-standard asset for a period of 12 months and
recovery of bank dues is of doubtful.

LOSS ASSETS:
Loss assets comprise assets where a loss has been identified by the bank or the RBI. These
are generally considered uncollectible. Their realizable value is so low that their continuance
as bankable assets is not warranted.

DEBT RESTRUCTURING
Once a borrower faces difficulty in repaying loans or paying interest, the bank should initially
address the problem by trying to verify whether the financed company is viable in the long
run. If the company/ project is viable, then rehabilitation is possible by restructuring the
credit facilities. In a restructuring exercise, the bank can change the repayment or interest
payment schedule to improve the chances of recovery or even make some sacrifices in terms
of waiving interest etc.

RBI has separate guidelines for restructured loans. A fully secured standard/ sub-standard/
doubtful loan can be restructured by rescheduling of principal repayments and/or the interest
element. The amount of sacrifice, if any, in the element of interest, is either written off or
provision is made to the extent of the sacrifice involved. The sub-standard accounts/doubtful
accounts which have been subjected to restructuring, whether in respect of principal
installment or interest amount are eligible to be upgraded to the standard category only after a
specified period.

To create an institutional mechanism for the restructuring of corporate debt, RBI has devised
a Corporate Debt Restructuring (CDR) system. The objective of this framework is to ensure a
timely and transparent mechanism for the restructuring of corporate debts of viable entities
facing problems.
OTHER RECOVERY OPTIONS
If rehabilitation of debt through restructuring is not possible, banks themselves make efforts
to recover. For example, banks set up special asset recovery branches which concentrate on54
recovery of bad debts. Private and foreign banks often have a collections unit structured
along various product lines and geographical locations, to manage bad loans. Very often,
banks engage external recovery agents to collect past due debt, who make phone calls to the
customers or make visits to them. For making debt recovery, banks lay down their policy and
procedure in conformity with RBI directives on recovery of debt.

The past due debt collection policy of banks generally emphasizes on the following at the
time of recovery:

• Respect to customers

• Appropriate letter authorizing agents to collect

• Due notice to customers

• Confidentiality of customers' dues

• Use of simple language in communication and maintenance of records of communication

In difficult cases, banks have the option of taking recourse to filing cases in courts, Lok
Adalats, Debt Recovery Tribunals (DRTs), One Time Settlement (OTS) schemes, etc. DRTs
have been established under the Recovery of Debts due to Banks and Financial Institutions
Act, 1993 for expeditious adjudication and recovery of debts that are owed to banks and
financial institutions. Accounts with loan amount of Rs. 10 lakhs and above are eligible for
being referred to DRTs. OTS schemes and Lok Adalats are especially useful to NPAs in
smaller loans in different segments, such as small and marginal farmers, small loan borrowers
and SME entrepreneurs.

If a bank is unable to recover the amounts due within a reasonable period, the bank may write
off the loan. However, even in these cases, efforts should continue to make recoveries.

SARFAESI ACT, 2002

Banks utilize the Securitization and Reconstruction of Financial Assets and Enforcement of
Security Interest Act, 2002 (SARFAESI) as an effective tool for NPA recovery. It is possible
where non-performing assets are backed by securities charged to the Bank by way of
hypothecation or mortgage or assignment. Upon loan default, banks can seize the securities
(except agricultural land) without intervention of the court.

The SARFAESI Act, 2002 gives powers of "seize and desist" to banks. Banks can give a
notice in writing to the defaulting borrower requiring it to discharge its liabilities within 60
days. If the borrower fails to comply with the notice, the Bank may take recourse to one or
more of the following measures:

• Take possession of the security for the loan

• Sale or lease or assign the right over the security

• Manage the same or appoint any person to manage the same

The SARFAESI Act also provides for the establishment of asset reconstruction companies
regulated by RBI to acquire assets from banks and financial institutions. The Act provides for
sale of financial assets by banks and financial institutions to asset reconstruction companies
(ARCs). RBI has issued guidelines to banks on the process to be followed for sales of
financial assets to ARCs.