Loans and Advances

Lending of funds to traders, businessmen and industrial enterprises is one of the

important activities of commercial banks. The major part of the deposits received by
banks is lent out, and a large part of their income is earned from interest on such lending.
There is a considerable difference between the rate of interest which the commercial bank
grants on deposits, and the rate they charge on loans and advances. It is this difference
which constitutes the main source of bank earnings.

Operation and expansion of business and commercial activities depend a great deal on the
availability of loans/advances from commercial banks. In this lesson, you will learn about
the procedure of getting loans and advance, cash credits, overdrafts, etc from the
commercial banks.

Objectives

 Enlist the utility of granting loans and advances by commercial banks

 Differentiate borrowing rates from lending rates
 Enumerate the ways of lending money
 Distinguish between long-term and short-term loans
 Point out the nature of security provided for loans and
 Outline the procedure for grant of cash credit, overdraft and discounting of bills of
exchange.

Meaning of Loans and Advances

The term ‘loan’ refers to the amount borrowed by one person from another. The amount
is in the nature of loan and refers to the sum paid to the borrower. Thus from the view
point of borrower, it is ‘borrowing’ and from the view point of bank, it is ‘lending’. Loan
may be regarded as ‘credit’ granted where the money is disbursed and its recovery is
made on a later date. It is a debt for the borrower. While granting loans, credit is given
for a definite purpose and for a predetermined period. Interest is charged on the loan at
agreed rate and intervals of payment. ‘Advance’ on the other hand, is a ‘credit facility’
granted by the bank. Banks grant advances largely for short-term purposes, such as
purchase of goods traded in and meeting other short-term trading liabilities. There is a
sense of debt in loan, whereas an advance is a facility being availed of by the borrower.
However, like loans, advances are also to be repaid. Thus a credit facility- repayable in
installments over a period is termed as loan while a credit facility repayable within one
year may be known as advances. However, in the present lesson these two terms are used
interchangeably.

Utility of Loans and Advances

Loans and advances granted by commercial banks are highly beneficial to individuals,
firms, companies and industrial concerns. The growth and diversification of business
activities are effected to a large extent through bank financing. Loans and advances
granted by banks help in meeting short-term and long term financial needs of business
enterprises. We can discuss the role played by banks in the business world by way of
loans and advances as follows

o Loans and advances can be arranged from banks in keeping with the
flexibility in business operations. Traders may borrow money for day to
day financial needs availing of the facility of cash credit, bank overdraft
and discounting of bills. The amount raised as loan may be repaid within a
short period to suit the convenience of the borrower. Thus business may be
run efficiently with borrowed funds from banks for financing its working
capital requirements.

o Loans and advances are utilized for making payment of current liabilities,
wage and salaries of employees, and also the tax liability of business.

o Loans and advances from banks are found to be ‘economical’ for traders
and businessmen, because banks charge a reasonable rate of interest on
such loans/advances. For loans from money lenders, the rate of interest
charged is very high. The interest charged by commercial banks is
regulated by the Reserve Bank of India.

o Banks generally do not interfere with the use, management and control of
the borrowed money. But it takes care to ensure that the money lent is used
only for business purposes.

o Bank loans and advances are found to be convenient as far as its repayment
is concerned. This facilitates planning for future and timely repayment of
loans. Otherwise business activities would have come to a halt.

o Loans and advances by banks generally carry element of secrecy with it.
Banks are duty-bound to maintain secrecy of their transactions with the
customers. This enhances people’s faith in the banking system.
 Borrowing Rate and Lending Rate

People make their funds available to the banks by depositing their ‘savings’ in various
types of accounts. In other words, bank funds mainly consist of deposits from the public,
though banks may also borrow money from other institutions and the Reserve Bank of
India. Banks thus mobilizes funds through its deposits. On public deposits the banks pay
interest at and the rate of interest varies according to the type of deposit. The borrowing
rate refers to the rate of interest paid by a bank on its deposits. The rates which the banks
allow depend upon the nature of deposit account and the period for which the deposit is
made with the bank. No interest is generally paid on current account deposits. The rate is
relatively lower on savings account deposits. Higher rates ranging from 6% to 12% per
annum are paid on fixed deposit accounts according to the period of deposit.

Banks also borrow from other institutions as well as from the Reserve Bank of India.
When the Reserve Bank of India lends money to commercial banks, the rate of interest it
charges for lending is known as ‘Bank Rate’.

The rate at which commercial banks make funds available to people is known as
‘Lending-rate’. The lending rates also vary depending upon the nature of loans and
advances. The rates also vary according to the purpose in view. For example if the loan is
sanctioned for the purpose of activities for the development of backward areas, the rate of
interest is relatively lower as against loans and advances for commercial/business
purposes. Similarly for smaller amounts of loan the rate of interest is higher as compared
to larger amounts. Again lending rates for consumer durables, e.g. loans for purchase of
two-wheelers, cars, refrigerators, etc. are relatively higher than for commercial
borrowings.

However, the Reserve Bank of India from time to time announces changes in the interest-
rate structure to regulate the lending of funds by banks. Different rates of interest are
prescribed for various categories of advances, such as advances to agriculture, small scale
industries, road transport, etc. Graded rates of interest are prescribed for backward areas.
Lower rate is normally charged from agencies selling food-grains at fixed price through
Govt. approved outlets. Lastly, lower rate of interest is charged for loans granted to
persons belonging to ‘weaker sections of the society’.

Lending of Money

Commercial banks lend money in four different ways: (a) direct loans, (b) cash credit, (c)
overdraft, and (d) discounting of bills.
These are briefly discussed below:
  Loans
Loan is the amount borrowed from bank. The nature of borrowing is that the money is
disbursed and recovery is made in instalments. While lending money by way of loan,
credit is given for a definite purpose and for a pre-determined period. Depending upon
the purpose and period of loan, each bank has its own procedure for granting loan.
However the bank is at liberty to grant the loan requested or refuse it depending upon its
own cash position and lending policy. There are two types of loan available from banks :
(a) Demand loan, and
(b) Term loan

A Demand Loan is a loan which is repayable on demand by the bank. In other words, it
is repayable at short-notice. The entire amount of demand loan is disbursed at one time
and the borrower has to pay interest on it. The borrower can repay the loan either in lump
sum (one time) or as agreed with the bank. For example, if it is so agreed the amount of
loan may be repaid in suitable installments. Such loans are normally granted by banks
against security.
The security may include materials or goods in stock, shares of companies or any other
asset. Demand loans are raised normally for working capital purposes, like purchase of
raw materials, making payment of short-term liabilities.

Term Loans: Medium and long term loans are called term loans. Term loans are granted
for more than a year and repayment of such loans is spread over a longer period. The
repayment is generally made in suitable installments of a fixed amount. Term loan is
required for the purpose of starting a new business activity, renovation, modernization,
expansion/ extension of existing units, purchase of plant and machinery, purchase of land
for setting up of a factory, construction of factory building or purchase of other
immovable assets. These loans are generally secured against the mortgage of land, plant
and machinery, building and the like.

 Cash credit

Cash credit is a flexible system of lending under which the borrower has the option to
withdraw the funds as and when required and to the extent of his needs. Under this
arrangement the banker specifies a limit of loan for the customer (known as cash credit
limit) up to which the customer is allowed to draw. The cash credit limit is based on the
borrower’s need and as agreed with the bank. Against the limit of cash credit, the
borrower is permitted to withdraw as and when he needs money subject to the limit
sanctioned. It is normally sanctioned for a period of one year and secured by the security
of some tangible assets or personal guarantee. If the account is running satisfactorily, the
limit of cash credit may be renewed by the bank at the end of year. The interest is
calculated and charged to the customer’s account. Cash credit, is one of the types of bank
lending against security by way of pledge or Hypothetication of goods. ‘Pledge’ means
bailment of goods as security for payment of debt. Its primary purpose is to put the goods
pledged in the possession of the lender. It ensures recovery of loan in case of failure of
the borrower to repay the borrowed amount. In ‘Hypothetication’, goods remain in the
possession of the borrower, who binds himself under the agreement to give possession of
goods to the banker whenever the banker requires him to do so. So Hypothetication is a
device to create a charge over the asset under circumstances in which transfer of
possession is either inconvenient or impracticable.

 Overdraft

Overdraft facility is more or less similar to ‘cash credit’ facility. Overdraft facility is the
result of an agreement with the bank by which a current account holder is allowed to
draw over and above the credit balance in his/her account. It is a short-period facility.
This facility is made available to current account holders who operate their account
through cheques. The customer is permitted to withdraw the amount of overdraft allowed
as and when he/she needs it and to repay it through deposits in the account as and when it
is convenient to him/her.
Overdraft facility is generally granted by a bank on the basis of a written request by the
customer. Sometimes the bank also insists on either a promissory note from the borrower
or personal security of the borrower to ensure safety of amount withdrawn by the
customer. The interest rate on overdraft is higher than is charged on loan. The following
are some of the benefits of cash credits and overdraft:-

1. Cash credit and overdraft allow flexibility of borrowing, which depends upon the
need of the borrower.
2. There is no necessity of providing security and documentation again and again for
borrowing funds.
3. This mode of borrowing is simple and elastic and meets the short term financial
needs of the business.

 Discounting of Bills
Apart from sanctioning loans and advances, discounting of bills of exchange by bank is
another way of making funds available to the customers. Bills of exchange are negotiable
instruments which enable debtors to discharge their obligations to the creditors. Such
Bills of exchange arise out of commercial transactions both in inland trade and foreign
trade. When the seller of goods has to realize his dues from the buyer at a distant place
immediately or after the lapse of the agreed period of time, the bill of exchange facilitates
this task with the help of the banking institution. Banks invest a good percentage of their
funds in discounting bills of exchange. These bills may be payable on demand or after a
stated period. In discounting a bill, the bank pays the amount to the customer in advance,
i.e. before the due date. For this purpose, the bank charges discount on the bill at a
specified rate. The bill so discounted is retained by the bank till its due date and is
presented to the drawee on the date of maturity. In case the bill is dishonored on due date
the amount due on bill together with interest and other charges is debited by the bank to
the customer’s account.

Long-term and Short-term Loans

Commercial banks grant loans for different periods-long, short and medium term for
different purposes.

(1) Short-term loans

Short term loans are granted by banks to meet the working capital needs of business. The
working capital needs refer to financial needs for such purposes as, purchase of raw
materials, payment of wages, electricity bill, taxes etc. Such loans are granted by banks to
its borrowers to be repaid within a short period of time not exceeding 15 months. Short
term loans are normally granted against the security of tangible assets like goods in stock,
shares, debentures, etc. The rate of interest charged on short term loans ranges from 12%
to 18% p.a.

(2) Term Loans

Medium and long term loans are generally known as ‘term loans’. These loans are
granted for more than 15 months. In case of medium term loan, the period ranges from 15
months to less than 5 years. Medium term loans are generally granted for heavy repairs,
expansion of existing units, modernization/renovation etc. Such loans are sanctioned
against the security of immovable assets. The normal rate of interest ranges between 12%
to 18% depending upon the period, purpose, nature and amount of the loan. Though
banks may grant long term loans, they avoid granting loan for more than 5 years.

Nature and Security of Loans

To ensure the safety of funds lent, the first and most important factor considered by a
bank is the capacity of borrowers to repay the amount of loan. The bank therefore, relies
primarily on the character, capacity and financial soundness of the borrower. But the
bank can hardly afford to take any risk in this regard and hence it also has the security of
tangible assets owned by the borrower. In case the borrower fails to repay the loan, the
bank can recover the amount by attaching the assets.

It can sell the assets offered as security and realize the amount. Thus from the view point
of security of loans, we can divide the loans into two categories: (a) secured, and (b)
unsecured. Unsecured loans are those loans which are not covered by the security of
tangible assets. Such loans are granted to firms / institutions against the personal security
of the owner, manager or director. On the other hand, Secured loans are those which are
granted against the security of tangible assets, likestock in trade and immovable property.
Thus, while granting loan against the security of some assets, a charge is created over the
assets of the borrower in favor of the bank. This enables the bank to recover the dues
from the customer out of the sale proceeds of the assets in case the borrower fails to
repay the loan.

There are various types of securities which may be offered against loans granted, but all
of those are not acceptable to the banks. The types of securities generally accepted by the
bank are the following:

 Tangible assets such as plant and machinery, motor-van, etc. Documents of title to
goods, like Railway Receipt (R/R), Bills of exchange, etc.
 Financial Securities (Shares and Debentures)
 Life-Insurance Policy
 Real estate (Land, building, etc).
  Fixed Deposit Receipt (FDR)
 Gold ornaments, Jewellery etc.

Procedure of granting Cash Credit, Overdraft and discounting Bills

The procedure of applying for and sanction of loans and advances differs from bank to
bank. However, the steps which are generally to be taken in all cases are as follow:

(I) Filling up of loan application form

Each bank has separate loan application forms for different categories of borrowers.
When you want to borrow money from a bank, you will have to fill up a loan application
form available with the bank free of cost. The loan application form contains different
columns to be filled in by the applicant. It includes all information required about the
borrower, purpose of loan, nature of facility (cash-credit, overdraft etc) required, period
of repayment, nature of security offered, and the financial status of the borrower. A
running business limit may be required to furnish additional information in respect of :

assets and liabilities

profit and loss for the last 2 to 3 years.
The names and addresses of three persons (which may include borrowers, suppliers,
customers and bankers) for reference purposes.

(2)Submission of form along with relevant documents

The loan application form duly filled in should be submitted to the bank along with the
relevant documents.

(3) Sanctioning of loan

The bank scrutinizes the documents submitted and determines the credit worthiness of the
applicant. If it is found to be feasible, the loan is sanctioned. If the loan is for Rs 5000 or
less, normally the Branch Manager himself can take the decision and sanction the loan. In
case the amount of loan is more than Rs
5000, the application is considered at regional, zonal or head office level, depending on
the amount of loan.

(4) Executing the Agreement

When the loan is sanctioned by the bank and the borrower is informed about it, he will
have to execute an agreement with the bank regarding terms and condition for the amount
of loan raised

(5)Arrangement of Security for Loan

The borrower will now arrange for security against the loan. These securities may be
immovable properties, shares, debentures, fixed deposit receipts, and other documents,
like, Kisan Vikas Patra, National Savings Certificate, as per agreement. When the
borrower completes all the formalities, he is allowed to get the amount of loan/advance/
over draft as sanctioned by the bank. In case of ‘discounting of bills’, the bank credits the
amount of bill to the customer’s account before the realization of the bill and thus, makes
available the fund. In case, the bill is dishonored on due date, the amount due on the bill
together with interest and other charges are payable by the party whose bill is discounted.