Banks must follow the below given principles while granting any loan:
1. Principle of liquidity
Banks lend public money which can be withdrawn by depositors at any time. Banks therefore advance loans on the security of such assets which are easily marketable and convertible into cash at a short notice.
A bank chooses such securities in its investment portfolio which possess sufficient liquidity. It is essential because if the bank needs cash to meet the urgent requirements of its customers, it should be in position to sell some securities at a very short notice without disturbing their market prices much. There are certain securities such as central, state and local government bonds which are easily saleable without affecting their market prices.
The shares and debentures of large industrial concerns also fall in this category. But shares and debentures of ordinary firms are not easily marketable without bringing down their market price. So banks should make investments in government securities and shares and debentures of reputed industrial or business houses.
2. Principle of Safety
Safety means that the borrower should be able to repay the loan with interest in time at regular intervals without default. The repayment of the loan depends upon the nature of security, the character of the borrower, his capacity to repay and his financial standing.
Like other investment, bank investment also involve risk. But the degree of risk varies with the type of security. Securities of central government are safer. The safety of bank’s fund depends upon the technical feasibility and economic viability of the project for which the loan is advanced.
3. Principle of diversity
In choosing its investment portfolio, a commercial bank should follow the principle of diversity. It should not invest its surplus funds in a particular type of security but in different types of securities. It should choose shares and debentures of different types of industries situated in different regions of the country. The same principle should be followed in case of state governments and local bodies. Diversification aims at minimising risk of the investment portfolio of a bank.
The principle of diversity also applies to the advancing of loans to varied types of firms, industries, business and trades. A bank should follow the maxim : “Do not keep all the eggs in the same basket.” It should spread risks by giving loans to various trades and industries in different parts of the country.
4. Principle of Stability
Another important principle of a bank’s investment policy should be to invest in those stocks and securities which has a high degree of stability in their price. The bank cannot afford any loss on the value of its securities. It should, therefore, invest its funds in the shares of reputed companies where the possibility of decline in their prices is remote.
5. Principle of Profitability
This is the cardinal principle for making investment by a bank. It must earn sufficient profits. Earning profit to satisfy shareholders and providing interest to the depositors is the main objective of a bank. To earn profit, pricing of products should be correct and competitive in comparison to others. It should be more than cost of fund and operating cost or base rate.
6. Principle of purpose
Bankers grant loans and advances to the customers only for productive purposes and not for hoarding or for speculative purposes. If the client is involved in speculative business, bankers must avoid such customers as they may drag the bank along with themselves at the time of downfall. The fund should be utilised for increasing production, turnover or for starting new business ventures, which generates employment. The business of borrower should be legal and as per the government’s policies. If the client is involved in a business against the government’s law, against the environmental policies or which may bring health hazards to the community it operates in, though the proposal may look attractive, banks should not make lending into those businesses.
Directives of the government with regard to any restriction, quantity, quality, quota or value wise imposition, should be in possession of that. Purpose of the advance must not only be productive and safe as stated above, but also it must have a definite source of repayment. By lending in short term requirements, liquidity must be ensured. Banks must never lend for speculative activities or for the purpose of hoarding stock. Banks must never forget their liability and responsibility towards the society.
7. Principle of risk minimization
Before providing loan, bank should be clear about the risk associated with the industry or firm. Taking risk is not only making aggressive lending in hazards area but before making loan in such area, bank should also analyze ownership risk, management risk, business risk and financial risk in investment area.
8. Principle of directives
Loans and advanced should be provided as per the directives of central bank or monetary authority. Central bank suggests to commercial banks to invest money on deprived sector, agriculture sector and creates ceiling for the investment in one sector.
