Lecture Retail and merchant banking – Lecture 19

After studying this chapter you will be able to understand: Basic lending principles, safety issues, diversification of risk, benefits of diversification, loans and advances, classification of loans, advances,...

Revise Lecture 19

‘Basic Lending

Principles

Basic Lending Principles

Safety Issues

Basic Lending Principles

Safety Issues

- The persistent failures of banks to lend sensibly in Pakistan and in many other countries have brought the question of Safety In lending to the fore;

- Why do banks persistently lend so

Imprudently and how should lending be done at minimum risk?

Basic Lending Principles

Safety Issues

‘ One essential problem is the human and managerial challenge of motivating

employees of banks to cater to the interest

of the owners (Shareholders) of the bank

- The history of banking Is replete with

episodes of employees favouring friends and relatives with loans

Basic Lending Principles

Safety Issues

- In some countries, there are well-defined

market rates for bribes for obtaining loans

from banks

- This problem ts also present in Pakistan, though the record of Pakistan’s banking system in this aspect is much better than that of many other countries

Basic Lending Principles

Safety Issues

* Another aspect of the problems of banks concerns prudent levels of leverage

- A bank ts a financial intermediary with

fairly small equity capital, which borrows money from depositors and invest It into risky assets This involves a high degree

of leverage

Basic Lending Principles

Safety Issues

- Leverage, at the level of the bank, is

dangerous regardless of the quality of

credit analysis which has gone into each loan

- High leverage generates high risk and

high returns If high returns are obtained, the bank takes the profits but it Is

protected from high losses by the

government

Basic Lending Principles

Safety Issues

- Regulators have tried many policy

Initiatives aimed at obtaining a banking

system which has controlled leverage,

high quality lending and thus, a reduced

risk of failure

- These include capital adequacy

requirements based on clumsy

measurement of risk, prohibition of lending

against real estate, restrictions on lending

Basic Lending Principles

Safety Issues

* Ariskless loan Is one that Is fully

collateralised using actively traded assets

‘ These assets should be traded objects so that a ‘market to market’ can be done

daily, to ensure that the collateral is always larger than the outstanding loan

- The value of the asset that is measured

when marking to market should be the

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Diversification of Risk

Basic Lending Principles

Diversification of Risk

‘ Diversification in banking has been a topic

of discussion in the literature for decades

- |t effects on performance, risk, efficiency and firm value have been examined

extensively

- Diversification does have a significant

impact on a bank’s risk as well as Its

performance

Basic Lending Principles

Benefits of Diversification

Basic Lending Principles

Benefits of Diversification

- One of the most common benefits

associated with respect to diversification Is

a lower cost of capital

- Banks, with some level of global

diversification have access to different

capital markets which could lead toa

lower cost of funds through a larger

deposit base

Basic Lending Principles

Benefits of Diversification

- Furthermore, the potential for more

efficient internal capital markets Is another

of cited benefit to diversification

- Another benefit associated with activity

diversification is the ability to gain

economies of scale / scope for the

organization

Basic Lending Principles

Benefits of Diversification

- An example might be bank which collects Information credit information on potential borrowers With this information, the bank may be able to offer these potential clients Insurance products or underwriting

services at a lower cost because much of the information needed has already been collected when evaluating the loan

application

Basic Lending Principles

Benefits of Diversification

- Benefits associated with market power

have also been advanced The argument Suggests that banks may diversify their

activities or their operations geographically

to gain or maintain market share

* Finally, an important benefit that has been proposed by some Is the ability for

organizations to reduce earnings volatility

by spreading operations across areas with

Lecture 20

‘Loans and Advances

Loans and Advances

- Lending money Is one of the two major

activities of any bank

- The bank acts as an intermediary between the people who have the money to lend

and those need money to carry out

business transactions

Loans and Advances

‘ Aloan Is granted for a specific time period

- Generally, commercial banks provide

Short-term loans But term loans, |.e loans for more than a year, may also be granted

- The borrower may be given the entire

amount in lump sum or In installments

Loans and Advances

- Loans are generally granted against or In exchange of the ownership (physical or constructive)of various type of tangible

items

- Some of the securities against which the banks lend are;

Loans and Advances

‘Classification of

Loans

Loans and Advances

- Bank loans can be classified as follows

according to the activity being financed;

1 Priority sector lending

2 Commercial lending

Loans and Advances

Priority sector lending

- The Government of Pakistan, through the instrument of SBP, mandates certain types

of lending on the banks operating in

Pakistan irrespective of their origin

- SBP sets targets in terms of percentage

(of total money lent by the banks) to be

lent to certain sectors which, In Its

perception, would not have access to

organized lending market or could not

Loans and Advances

Priority sector lending

- This type of lending is called priority sector lending

* Financing of small industry, small

business, agricultural activities and export activities fall under this category

- This ts also called directed credit in the

Pakistan banking system

Loans and Advances

Commercial lending

- Commercial lending is the mainstay of Pakistan banking, its bread and butter activity

* Historically, this activity had been

relegated to a secondary position as

banks were driven by the desire to excel

Loans and Advances

customer who forms the core of this

business There Is big competition among banks to secure bigger share of this

business

Loans and Advances

Commercial lending

- At present, commercial loans are available for practically any kind of activity and also for both long and short tenures

- Based on customer profile, these loans

Advances

Loans and Advances

* An advance is a credit facility provided by the bank to Its customers

- |t differs from a loan in the sense that the latter may be granted for a longer period, but the former are normally granted fora Short period of time

Loans and Advances

- Further, the purpose of granting advances

is to meet the day-to-day requirements of business

- The rate of interest charged on advances varies from one bank to another

Loans and Advances

* Bank grant short-term financial assistance

by way of;

1 Cash credit

>» Overdraft

3, Discounting of bills

Loans and Advances

Cash Credit

- Cash credit is an arrangement whereby the bank allows the borrower to draw

amount up to a specified limit

- The amount is credited to the account of the customer The customer can withdraw

this amount as when he requires The

interest Is charged on the amount actually

withdrawn.

Loans and Advances

Cash Credit

Cash credit is granted as per the terms

and conditions agreed upon with the

customers This type of financing Is similar

to a line of credit

Advances against the Security of Goods

2 Advances against Life Insurance Policies

3, Advances against Stock Market

Securities

Loans and Advances

Cash Credit

4 Advances against Fixed Deposit Receipts

5 Advances against Book debts

6 Advances against Real Estates

7 Advances against Supply Bills