Bank credit is the primary institutional source of working capital finance in India. Banks extend credit to different categories of borrowers for a wide variety of purposes. Bank credit is provided to households, retail traders, small and medium enterprises (SMEs), corporate, the Government undertakings etc. in the economy.
Principles of Lending
- Safety: The repayment of loans depends on the borrowers’ capacity to pay. Hence, the banker has to be satisfied before lending that the business for which money is sought is a sound one. Bankers may insist on security against the loan on which they fall back on if repayment does not happen. The security must be adequate, readily marketable.
- Liquidity: To maintain liquidity, banks have to ensure that money lent out by them is not locked up for long time. Hence, they design a loan maturity period. If loans become excessively illiquid, it may not be possible for bankers to meet their obligations toward depositors.
- Profitability: To remain in business, a bank earns profit on its investment through appropriate fixing of interest rates on both advances and deposits.
- Risk diversification: To mitigate risk, banks should lend to a diversified customer base. This diversification is done with regard to of geographic location, nature of business etc.
The different forms in which the bank normally provides loans and advances are as follows:
- Loans
- Cash credits
- Overdrafts
- Purchasing and discounting of bills
When a bank makes an advance in lump-sum against some security it is called a loan. Commercial banks generally provide short term loans up to one year for meeting working capital requirements. The term loans may be either medium-term or long term loans. In case of a loan, a specified amount is sanctioned by the bank to the customer.
The entire loan amount is paid to the borrower either in cash or credit to his account. The borrower is required to pay interest on the entire amount of the loan from the date of the sanction. A loan may be repayable in lump sum or installments. Interest on loans is calculated at quarterly rests and where repayments are stipulate in installments, the interest is calculated at quarterly rests on the reduced balances.
Banks engage now in a wide variety of short-term and long-term lending activities.
Infrastructure Projects: According to operational guidelines issued on April 23, 1999 by RBI on financing of infrastructure projects to banks, they are free to sanction term loans for technically feasible, financially viable and bankable projects undertaken by both public and private sector undertakings subject to prescribed criteria. In this context, four broad modes of financing were identified. These are
- financing through funds raised by way of subordinated debt
- entering into take out financing
- direct financing through rupee term loans, deferred payment guarantees and foreign currency loans
- investment in infrastructure bonds issued by project promoters/FIs
Loans for Working Capital: Working capital finance is utilized for operating purposes, resulting in creation of current assets like inventories and receivables. This is in contrast to term loans which are utilized for establishing or expanding a manufacturing unit by the acquisition of fixed assets. Banks carry out a detailed analysis of borrowers’ working capital requirements. Credit limits are established in accordance with the process approved by the board of directors.
RBI has been encouraging the Indian corporate sector to avail of working capital finance in two ways: a short-term loan component and a cash credit component. The loan component would be fully drawn, while the cash credit component would vary depending upon the borrower’s requirements.
Syndicated Loan: The other source for raising working capital is syndicated loan. It is available for large established public limited companies. This is a loan offered by a group of lenders (called a syndicate) who work together to provide funds for a single borrower. Interest rates can be fixed or floating based on a benchmark rate such as the London Interbank Offered Rate (LIBOR).
Syndicated loan for working capital is an alternative to the rigid terms of the bank the borrower faces. It offers a good avenue to get the appropriate level of credit as determined by requirements of the unit rather than policy posture and price determined by credit rating of the borrower. Major benefits reaped by corporates in syndication are amount, tenor and price.
Loans to Small and Medium Enterprises (SME): Banks use simplified credit appraisal methods for assessment of bank finance for the smaller units. Banks have also been advised that they should not insist on collateral security for loans up to Rs.10 lakh for the micro enterprises.
Small Industries Development Bank of India (SIDBI) also facilitates the flow of credit at reasonable interest rates to the SME sector. This is done by incentivising banks and State Finance Corporations to lend to SMEs by refinancing a specified percentage of incremental lending to SMEs, besides providing direct finance along with banks.
Export Credit: Export credit is a loan facility that is extended to an exporter by a commercial bank in the exporter’s country. In other words, this involves a direct loan to a foreign buyer of domestic goods and services, or to a guarantee for a private loan to a domestic exporter. The loan essentially guarantees that the domestic exporter will be paid.
Leasing: This is a process by which a company acquires the use of a certain fixed assets for which it must pay a series of periodic (tax deductible) payments. The ‘lessee’ is the receiver of these assets under the ‘lease’ contract. The ‘lessor’ is the owner of the assets, in this case it is the bank. The Reserve Bank allows banks to take direct exposures in areas like equipment leasing, hire purchase and factoring. According to RBI guidelines, bank’s exposure to lease financing should not exceed 25 percent of net worth in the case of an individual borrower and 50 percent in the case of a group of borrowers.
Types of leases
- Sale and lease back arrangements: Under this lease a firm that owns the asset (building, land and equipment) sells the asset and simultaneously executes an agreement to lease the asset back for a specified period on specific terms.
- Operating leases: Here, the lessor is to maintain and service the leased asset and the cost of such maintenance is built into the lease payment.
- Straight financial or capital lease: A financial lease is a long-term agreement extending over the estimated economic life of the asset. The lessor agrees to finance the use of the equipment by the lessee over time and is not subject to cancellation by the lessee before the end of the base lease period.
- Leveraged leases: This is a lease where the lessor pays some of the money required to purchase the asset and borrows the rest from a lender. The lender is given a secured interest on the asset and an assignment of the lease and lease payments. The lessee makes payments to the lessor, who makes payments to the lender.
- Housing Finance: Housing finance provided by a bank involves the acquisition or construction of houses, including acquisition or development of land in connection therewith. Commercial banks make mortgage loans for land, construction or a completed dwelling unit either a flat in or multi-storied building or an independent unit. The cost of financing to the borrower depends on the level of interest rates, term to maturity and whether the mortgage is fully amortised and has fixed or variable interest rates.