Principles Of Good Lending System – When it comes to bank lending the first question that comes to thought is what are the principles of good lending that bankers should know?
Of cause whenever, a customer comes to a bank to borrow money from the bank, the bank official must convince themselves that the borrower is qualified for such request.
To strictly adhere to the canons or principle of good lending, the response of the bank may either be favourable or unfavourable as regards to the request for a loan. But before this lending is granted, the customer must request initially for the specific lending or borrowing proposition.
The banker has the task to either accept the proposition as it is, or the preposition is out rightly rejected. The guide for the banker is the principles of good lending, which would help the banker to see that the proposal is;
- Financially viable that is whether there is sufficient funds to carry out the project and sources of the funds. Cost overrun must be guided against which means that the effect of changes in general price level must not affect the cost of the project. And also the contract cost of the project is viable or fixed. The project must be commercially viable meaning there must be ease of and buying and selling. The proposition must be technically viable hence the need to adapt to the best methods of granting advances. Machineries whether they could be sourced locally or imported. Good management team to ensure the successful management of business. Experts should be used in production, marketing, financial, distribution as well as other factors. In fact for any propositions presented to a banker, it should be considered under the following headings;
- Purpose of the loan
- Amount – How much and what is the stake of the proposer.
- Repayment – What is the source of repayment and for how long?
- Terms of the loan.
- Security to be offered in case at the 3Cs
- Capital which is concerned with the customers stake and how much of the risk capital is being provided by the borrower.
- Capability is concerned with the source of repayments as principles of good lending implies that borrowers must always repay fund borrowed, the capability of the borrower to make the planned repayments out of the income or profit.
- Character is concerned with the type of person the borrower is, at least in the judgement of the banker.
Principles Of Good Lending And Credit Analysis
In credit analysis there are basic principles of good lending which can guide a bank in averting a possible moral hazard, they include;
Purpose – The purpose of taking the loan should be properly analysed to see if the project will be self liquidation is to come from another source. The purpose of taking the loan will also give an idea on whether the loan is for short term, or medium term or long term borrowings as the case may be. Banks could lend money for repayment of current liabilities by its customers, but banks should not lend for over-due current liabilities like taxes, dividend and creditors. But the proposal should also be well scrutinized before any money should be lent out. Banks do not lend for speculative/gambling purposes. Purpose of the loan may also reveal whether the project is a legal or illegal one. This can also be supported by the provisions of memorandum and articles of association of the borrowing company.
The customer must specify the purpose of the advance he wants the banker to give him. This is a requirement for personal loans as well as business loans as the case may be. In a case where there is an advance to business, the purpose of the loan might give some indications about the ability or willingness of the customer to repay the loan on time and as when due. The customer will then be required to indicate what he wants to use the loan for which may be of the following;
- Purchase of fixed assets
- Purchase of current assets
- Financing current liabilities
In order to observe the best principles of good lending, the banker has to begin by affording the borrower to state what he wants to use the loan for, here the customer is helping the bank to know whether the loan will be self liquidating, short term or long term, fluctuating or sold and whether the loan will improve the stability of the business or indeed worsen the situation. Loans for certain other purposes should be turned down, these are;
- Loans for illegal purposes must always be refused by bankers.
- Loans to a company for a project whether is not permitted by the object clause in its memorandum of association must always be turned down.
Amount Of The Loan – The amount to be borrowed should be compared with the cost of the project because if insufficient amount is lent, their is a possibility that the project will always be left unfinished, half way without any other fund to complete it. Also it is believed that if a customer is committing himself with much of his fund in a project, their is a possibility that he is not going to relax on his efforts in seeing that the project survives so that his stake does not go down the drains.
But the amount each customer should contribute to the project depends on the other circumstances surrounding the project and the companies involved. Usually, corporate bodies are expected to put in two third of the project cost, while personal loan requires personal loan requires one fifth of the loan to be contributed by the borrower, and the amount required by customers should be supported by a cash project budget so that future cash flow can be determined or forecasted.
One of the principles of good lending entails that the customer must specify how much money he wants to borrow and the banker ought to consider the customer has asked for as much as he really needs, the most suitable methods of trying to decide whether the customer has asked for an advance as much as he really needs are;
- Study the budget prepared by the customer
- Study the balance sheet of the customer and his likely working capital position and liquidity after the advance has been made. If the banker suspects that the customer should be short of liquid funds, he should suggest to the customer that he has estimated his borrowing requirement incorrectly and discuss the problem
Again when a customer asked for an advance he should be expected to put up some money himself towards the investment for the following reasons;
- If the customer has a substantial stake himself in the investment losses will first be borne by the customer before the banker’s stake is endangered.
- If the customer puts some of his own money into the venture he is more likely to put his greatest efforts into ensuring that the venture succeeds.
At this point one may be tempted to ask what should be the customer’s contribution in any particular venture, however, it may depend on the circumstances and we shall be looking at both business and personal customers.
- Business Customer – a general guidline is that bank should not lend more than the customer invested in the business even the bank has obtained adequate security.
- Personal Customers – with the personal lending , the bank will often be relying on customer’s income from salaries or wages to repay the loan. Provided there is adequate security, a bank will be prepare to meet a greater proportion of the total expenditure. For example, a bank could lend up to ninety percent for mortgage proposition and in purchasing of a car, the bank may lend as much as two third of the cost.
Repayment Of The Loan – Repayment is the ability to pay back both the interest and principal sum as at when due. If there is any reason to doubt the ability of a customer to repay the loan, the bank should not lend. Profit projection is always used in projecting the ability of the customer to repay the loan at the appropriate time or period. This profit projection gives an idea of the level of profit a customer is going to make in a specific period of time under study. For example, company K is asking for a loan and presented profit and loss account of
Turnover 2.5 million
Purchases 2.5 million
Gross Profit 0.5 million
Over head 0.35 million
Tax 0.05 million
Net profit = 0.10 million
This will aid the banker to apply one of the 7 canons of bank lending, the banker will now determine whether to lend or not to lend. After profit projection, cash flow projection is next document to be asked for, and examine in order to determine how cash inflows and outflows will look like. Also the three years (3 years) balance sheets, and profit and loss account are called for and properly examined. All the above documents are for corporate customers. But for personal customers, a monthly income/expenditure statement is being asked for which will show his net balance every month from his monthly income after all the monthly expenditure.
Repayment of advance is the most important consideration in the lending decisions, the best principles of good lending hinges on the ability to repay loan as at when due. A banker should not lend if it seems unlikely that the customer will be able to afford the periodic repayments even if the banker is offered adequate security for such advance. It will not be appropriate for a banker to lead knowing that he will obtain repayment by selling security offered.
Finally sources of repayment is the most important consideration in principles of good lending decision, the source of repayment must be clear from the world go.
- In case of a personal customer, the source of repayment will probably be the customer’s regular monthly income from his monthly salary.
- In case of a business customer, the source of repayment will probably be the profit of the business.
The banker should therefore look for evidence by obtaining the following;
- A projection
- A cash flow projection indicating the maximum of amount needed and the timing and amount of eventual cash receipt.
- Information about the past trading record of the business for the past three years.
Terms Of The Loan – The terms of the loan is likely to be less than the life span of the project and never more than the life span. The purpose for which the loan is required will then determine the term of the advance which is clearly stated in the principles of good lending. Normally, over draft is renewable after 12 months while loan for capital expenditure like purchases of fixed assets is likely to be medium to long term loan. There must be clear agreement between the customer and the bank before drawing down of any advances.
Security For The Loan – A proposition should not be agreed on the basis that security can be realized if repayment is not forth coming. The proposition should be viable on its own merits with security taken only as a safeguard in the event of unforeseen circumstances.
In considering security, a bank is seeking something which has stability in value and could easily be realised. Land and buildings are the most suitable because they are stable and increase in value with time, but realisation in case need can prove difficult especially building in the rural areas and villages.
Stock exchange securities are another good securities but their value is not stable therefore adequate margin must be held and maintained. If a bank decides that securities must be given as a condition for an advance, he must establish;
- Whether there is any security available
- If security is available, can it be easily valued? Could it be sold off fairly easily?
- Is it an assets that has a stable or fluctuating value or a value that tends to increase over time.
In summary, the current value of a security must give sufficient margin over the amount of the advance to ensure that if the security does subsequently fall in value, the banker’s security shall not be threatened.