Tutorial 1 Answer

Chapter 1: The principles of lending and lending basics
Solutions to discussion questions

Q1. What factors have to be taken into account by a bank in considering an application
for an advance? (15 m)
A. The factors that banks generally take in to account when an application for advance is
received can be grouped in to three categories: external factors, internal factors and borrower
specific factors.
External factors involve examining whether the bank is authorised to lend for the purpose
intended. This involves asking questions like: Is the activity for which finance is sought
lawful? Does it comply with legislation that regulate bank lending (the Banking Act 1959,
Uniform Consumer Credit Code, ASIC Act 1989)? What macroeconomic factors may affect
lending decisions? Is the industry to which the borrowing firm belongs in good shape or are
there any problems peculiar to this industry? A bank cant lend for unlawful activity like
narcotics trade or financing terrorism, for example.
Internal factors refer to bank specific factors. This involves examination of aspects like
whether the activity conforms to the lending policy of the bank, how much loan budget is
available for the type of activity for which finance has been sought, and whether staff and
other resources are available to scrutinise, approve and subsequently monitor the
application? The top management of the bank may have decided not to lend for commercial
property in particular region, for example.
Borrowing specific factors include an examination of the traditional five Cs of lending.
The five Cs approach involves assessment of character, capacity, capital, conditions, and
collateral. Character assessment involves collecting information about the borrowers
track record of integrity, repayment ability and spending habits. Capacity refers to the ability
to repay the loan together with interest as per a predetermined schedule. Capital refers to the
capital contribution or own contribution that the borrower will make out of the total
resources. Conditions refer to the macroeconomic conditions that affect lending as well as
the terms and conditions subject to which the bank may be prepared to finance. Collateral
refers to the security that underlies the finance. It is something that the bank can fall back
up on in the event of default.
If the above factors are favourable, the bank may consider granting an advance.
Q.2. What is creditworthiness and how can it be determined? (3 m)
A. Credit worthiness means whether the prospective borrower is worthy of receiving
requested credit (finance). This worthiness is determined by following the five Cs approach
as explained above. Where a lending institution feels that the prospective borrower may be
entitled or worthy of receiving lower than the requested credit, it may slash the amount
requested suitably.
Q3. Why do banks require a customer to contribute some of the capital required for a
project? (10 m)
Banks and other lending institutions invariably expect that the prospective borrower
contribute at least a part of the total cost of a project, the remaining portion to be financed out
of bank loan. The contribution that a prospective borrower makes is called borrowers
margin or borrowers capital.
The reason why lending institutions usually ask for it is to create a stake for the
borrower in the project. When the borrowers own money is involved, the borrower will
automatically work sincerely and diligently to ensure success of the project, which in turn
will lead to repayment of loan together with interest.
The capital contributed by the borrower also reduces the lenders risk exposure.
Hence, the higher such capital contribution, the less risky it is for the bank. In case of home
loans, for example, lending institutions require borrower to contribute at least 20 per cent of
the total cost, thus ensuring that the loan-to-value ratio is 80 per cent. Where the loan-to-value
ratio is more than this, that is, where it is say 90 per cent (10 per cent being contributed by
borrower), lenders usually insist on mortgage insurance.
The riskier the loan, the more capital contribution lenders require borrower to
make. In margin loans (finance for purchase of shares in listed companies), the portion that
the borrower contributes is 30 per cent in case of blue chip companies and may be 40 or 50
per cent in case of other companies. Thus, the capital contribution that lenders expect
borrowers to make shows how risky the lender considers the activity for which finance is
sought.
Q4. Distinguish between a loan and an overdraft. (10 m)

A. Traditionally, bank finance is classified between these two major categories, loan and
overdraft. There are many points of difference between a loan and an overdraft:
Loan
Overdraft
A loan is a fixed sum of money advanced by An overdraft is like a running account
a bank as one lump sum payment.
subject to a limit.
The purpose for which a loan may be given An overdraft is usually given for meeting
is generally to purchase an asset like plant operational expenses or working capital as it
and machinery or house.
is called in business terminology.
However, in the case of loan account, there As a running account there could be many
will be debits only towards lump sum debits and credits in an overdraft account.
advanced and periodical interest and fees.
There could be credits that represent
periodical repayments
A loan is generally given against collateral
An overdraft may not be secured by
collateral, that is, it may be clean or
unsecured.
no such chequebook is necessary for A chequebook is usually issued to the
borrowers of a loan
borrower who has been allowed an overdraft
Loan repayments are made by equated Overdrafts do not involve such periodical
periodical instalments
repayments. Thus, an overdraft account may
come in credit and again go in debit many
times during the period of overdraft.
Loans are generally given for medium to
long term. The period may vary from 3 to 5
years or even up to 25 years.
In the case of loan, the interest amount is
included in the equated monthly or
fortnightly instalment that the borrower has
to pay.
The borrower may be charged a prepayment
penalty in the case of repayment of a loan
earlier than scheduled.
Overdrafts are usually given for a short

period of time, say one year. These can,
however, be renewed at the end of the year.
Interest is charged on overdrafts on product
basis; that is, interest is charged on the
number of days an amount remains in debit.
There are no prepayment penalties in case
of an overdraft. The borrower can bring the
overdraft account in credit and may allow it
to remain like that for months.
Q6. What is credit analysis? What are the various steps involved in credit analysis? (10
m)
A. Credit analysis refers to the assessment of credit worthiness of the borrower or the
credit risk associated with a loan approval. The various steps involved in a typical credit
analysis are as under:
Step 1: Obtain prescribed loan application form duly completed and signed by the
prospective borrower.
Step 2: Obtain required documents and financial statements. This includes basic
documents of identity like borrowers driving licence, for example, or documents of
constitution like partnership deed in case of firms.
Step 3: Check the loan application form and attached documents for internal consistency.
Step 4: If all the information has been received, preliminary decision with regard to approval
or otherwise of a loan would be made at this stage.
Step 5: Conduct detailed appraisal of technical, commercial, financial and managerial
aspects of the loan proposal.
Step 6: Assess the financial requirements of the borrower and the type of facility to be
approved.
Step 7: If the proposal is approved send a letter conveying the approval to the borrower
advising to execute documents before loan disbursal could be made. Where the proposal is not
approved, reasons for rejection need to be recorded.
Step 8: Where the loan is approved it is important to ensure that all required documents are
executed before loan is disbursed to the borrower.
Step 9: Monitor the account periodically to ensure that it is running in order.
Step 10: Where the loan account is not in order, a hard core has developed in the account for
example, lender must take immediate action to avoid it from becoming a problem loan
account.
Q8. What are the different types of borrowers? (10 m)

A. Borrowers are broadly classified into two types: personal borrowers and business
borrowers. Personal borrowers are generally individuals, households and families. They
require loans to satisfy personal needs like travel, education, home repairs, expenses etc.
There are also some special types of personal borrowers. These include: minors, person of
unsound mind, insolvents, joint accounts etc. Minors are persons who have not attained 18
years of age. Minors have no capacity to contract and lending institutions should not make
loans to minors. Persons of unsound mind can enter into contract during the period in which
they are sound mind. Banks should not lend to an undischarged insolvent or a person against
whom insolvency proceedings are pending. Where an account is a joint account, the banker
must obtain joint holders clear and specific authority regarding one or more of the parties
overdrawing the account, taking an advance or charging a security.
Business borrowers could be sole proprietorship, partnership or a corporation. A sole
proprietorship is a business that an individual owner conducts in his/her own name or a
trade name. Partnership is a relation between persons who have agreed to share the profits
of a business carried on by all or any one of them acting for all. A company is an artificial
person created by law. Some other types of borrowers include local authorities, clubs,
literary societies and schools, unincorporated associations and co-operatives.
It is important for a lending banker to know the various types of borrowers because the
legal requirements in granting a loan significantly depend up on the category to which a
borrower belongs.
Q 9. What is meant by credit culture? Why is it so important? (5 marks)
A. Credit culture refers to institutional priorities, traditions and philosophies that surround
credit or lending decisions. Every organisation has its own culture that distinguishes it from
other competitors. Credit culture includes things such as strong customer orientation,
willingness for risk taking, response time to customers etc.
Credit culture is important as it prepares all employees to accordingly respond to
customers and situations in credit and lending decisions. It brings uniformity in response of
the lending organisation wherever its branch located and whoever may be the officer dealing
with a loan proposal. Once a strong credit culture is developed, the organisation gets
recognised for certain principles, actions, deterrents and rewards within it. This helps attract
customers. Lending organisations take considerable care to develop a proper credit culture. It
avoids its officers taking unnecessarily risky decisions and at the same time not losing to
competition in the wake of a possible opportunity.

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Chapter 1: The principles of lending and lending basics

Solutions to discussion questions

Q4. Distinguish between a loan and an overdraft. (10 m)

Overdrafts are usually given for a short

Q8. What are the different types of borrowers? (10 m)

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