Page 112 - DCOM208_BANKING_THEORY_AND_PRACTICE

Unit 7: Loans and Advances

5. A bank must offer advances to different firms belonging to different industries, which are Notes
situated over different geographical areas, so that he may not be badly affected by the
failure of one industry or a few big borrowers.
6. Maturity diversification: The most important form of diversification is maturity
diversification. The loan portfolio should be such that different loans and advances have
different maturity time. This results in continuous repayments throughout the year and
thereby maintains liquidity of bank.

7.4.4 Profitability

Equally important is the principle of profitability. The difference between the lending and
borrowing rates constitutes the gross profit of the bank. Banks need to earn profit for several
reasons:

1. Like other economic entities, banks must earn sufficient income to pay interest to the
depositors in order to meet establishment charges, pay dividends to owners, and retain a
portion of the income for the future growth, expansion and contingencies.
2. Lending rates are affected by the bank rate, interbank competition and interbank
agreements, where they have been agreed.
3. No banker will and should ordinarily think of an advance without a satisfactory margin
between the lending and borrowing rates.

4. Different rates are charged, depending on the credit risk involved in the lending to different
borrowers, type of loans, the nature of security, the mode of charge, the margin
requirement.

5. Advances should be given to customers after proper enquiry about the risk and credibility
associated with him. Also, proper guarantees must be taken.
A prudent banker will avoid making profit at the expense of the liquidity and safety of his
capital. Thus, within the limits of liquidity, safety, and the national policies as laid down by the
government and the Central Bank, a banker should strive for accomplishing the objective of
profitability.

7.4.5 Purpose

Bankers should always inquire about the purpose for which the loan is taken. As a matter of fact,
the safety and liquidity of loan depends on the purpose for which it will be put.
1. An advance given for productive purposes in all probability will be repaid because the
grant of the loan will generate additional income for the borrower to enable him to repay
it.
2. An advance made for nonproductive and speculative purposes is subject to greater credit
risk because the purpose for which the loan was sought would in no way improve the
repaying capacity of the borrower. Borrower may or may not be able to pay.

3. There are chances that funds borrowed for a productive use may be used for speculative
purposes. The banker (as far as possible) should, therefore, take follow-up steps to see that
the end-use of credit is not for a purpose other than for which it is taken.

Thus, a banker should avoid giving loans for wasteful expenditure, social functions and
speculative transactions.

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