“Once a person has confirmed a good set of principles with the help of accumulated knowledge, and a good order for those principles they will have the equivalent of a masters’ guide to life. “
Here is my attempt at jotting down the five most important principles of good lending when appraising an advance proposal.
1. Safety
"Safety first" is the most important principle of good lending. When a banker lends, he must feel certain that the advance is safe; that is, the money will definitely come back. If, for example, the borrower invests the money in an unproductive or speculative venture, or if the borrower himself is dishonest, the advance would be in jeopardy. Similarly, if the borrower suffers losses in his business due to his incompetence, the recovery of the money may become difficult. The banker ensures that the money advanced by him goes to the right type of borrower and is utilized in such a way that it will not only be safe at the time of lending but will remain so throughout, and after serving a useful purpose in the trade or industry where it is employed, is repaid with interest.
2. Liquidity
It is not enough that the money will come back; it is also necessary that it must come back on demand or in accordance with agreed terms of repayment. The borrower must be in a position to repay within a reasonable time after a demand for repayment is made. The source of repayment must also be definite. The reason why bankers attach as much importance to 'liquidity' as to safety' of their funds, is that a bulk of their deposits is repayable on demand or at short notice.
3. Purpose
The purpose should be productive so that the money not only remain safe but also provides a definite source of repayment. The purpose should also ensure liquidity. Purpose has assumed a special significance in the present day concept of banking in this ever changing market. Every banker must closely scrutinize the purpose for which the money is required, and ensure, as far as he can, that the money borrowed for a particular purpose is applied by the borrower accordingly.
4. Profitability
Many forget to realize but, banks must make profits too. Firstly, banks have to pay interest on the deposits received by them. They have to incur expenses on establishment. They have to make provision for depreciation of their fixed assets and for any possible bad or doubtful debts. After meeting expenditure which enter the running cost of banks, a reasonable profit must be made; otherwise, it will not be possible to carry anything to the reserve or pay dividend to the shareholders. It is sometimes possible that a particular transaction may not appear profitable in itself, but there may be some ancillary business available, such as deposits from the borrower's other concerns. In this way, the transaction may on the whole be profitable for the bank.
5. Spread
Another important principle of good lending is the diversification of advances. An element of risk is always present in every advance, however secure it might appear to be. In fact, the entire banking business is one of taking calculated risks and a successful banker is an expert in assessing such risks. He is keen on spreading the risks involved in lending, over a large number of borrowers, over a large number of industries and areas, and over different types of securities. For example, if he has advanced too large a proportion of his funds against only one type of security, he will run a big risk if that class of security steeply depreciates. Diversification is a key.