JAIIB PPB Paper-2 Module-B Unit 1: Principles of lending, Different types of borrowers & Types of credit facilities

10/03/2023

JAIIB Paper 2 (PPB) Module B Unit 1:Principles of lending, Different types of borrowers & Types of credit facilities (New Syllabus)

The Institute of Indian Banking and Finance (IIBF) has recently announced the revised syllabus and exam format for the JAIIB Exam 2023. The upcoming exam will comprise of four papers, with Paper 2 (Principles & Practices of Banking) covering Unit 1: Principles of lending, Different types of borrowers & Types of credit facilities. This particular unit holds significant importance for candidates, as it will greatly impact their performance in the exam.

To assist candidates in comprehending the topic, we will provide all the necessary details related to Unit 1: Principles of lending, Different types of borrowers & Types of credit facilities of JAIIB Paper 2 (PPB) Module B: Functions of Banks. We strongly recommend candidates to refer to this article and also utilize our Online Mock Test Series to enhance their understanding of Foreign Currency Accounts for Residents and other related aspects.

For candidates appearing for the JAIIB Certification Examination 2023, it is essential to comprehend each unit in the syllabus, including the Marketing unit. This unit holds great importance in the banking industry, and candidates must prepare thoroughly to excel in the exam and establish a successful career in the banking sector.

Principles of Lending

The Business of lending is not without certain risks, especially when the lending banks depend largely on the on the borrowed funds. The cardinal principles of lending are, therefore, as follows:

Safety
Liquidity
Diversity
Purpose
Stability
Profitability

Liquidity: Liquidity is an important principle of bank lending. Bank lend for short periods only because they lend public money which can be withdrawn at any time by depositors. They, therefore, advance loans on the security of such assets which are easily marketable and convertible into cash at a short notice.

Safety: The safety of funds lent is another principle of lending. Safety means that the borrower should be able to repay the loan and 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.

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 the shares and debentures of different types of industries situated in different regions of the country. The same principle should be followed in the case of state governments and local bodies. Diversification aims at minimising risk of the investment portfolio of a bank.

Purpose: Loans for undersirable and speculative purposes cannot be granted. Although the earnings on such business activities may be higher, ever then a bank cannot resort to these loans.

Stability: Another important principle of a bank’s investment policy should be to invest in those stocks and securities which possess a high degree of stability in their prices. The bank cannot afford any loss on the value of its securities. It should, therefore, invest it funds in the shares of reputed companies where the possibility of decline in their prices is remote.

Profitability: This is the cardinal principle for making investment by a bank. It must earn sufficient profits. It should, therefore, invest in such securities which was sure a fair and stable return on the funds invested. The earning capacity of securities and shares depends upon the interest rate and the dividend rate and the tax benefits they carry.

Non- Fund Based Limits

While ascertaining the credit needs of the borrowers, the bankers should assess both the fund based and non fund based limits required by him together and sanction them as a package. The Non-fund based limits are normally of four types:

(i)Bank Guarantees

(ii)Letters of Credit

(iii)Underwriting and credit guarantee; and

(vi)Derivative

Bank Guarantees:

A bank guarantee refers to a promise provided by a bank or any other financial institution that if a certain borrower fails to pay a loan, then the bank or the financial institution will take care of the losses. The bank will assure the original creditor through this bank guarantee that if the borrower does not meet his or her liabilities, then the bank will take care of them.

While issuing the bank guarantee, the banker has to keep in mind the instructions of RBI with regard to certain purposes that prohibit the issue of bank guarantee and also the extended liability period that has been occasioned consequent to amendment of Section 128 of Indian Contract act with respect of Guarantees issue in favour of the government departments.

A bank guarantee is a contract between 3 different parties and they include:

The applicant (the party that requests a bank guarantee from the bank and borrows from a creditor)
The beneficiary (the party that receives a partial guarantee)
The bank (the party that agrees to sign and assures payment in case the applicant fails to repay the loan)

Letter of Credit (L/C):

A letter of credit is a document that guarantees the buyer’s payment to the sellers. It is Issued by a bank and ensures the timely and full payment to the seller. If the buyer is unable to make such a payment, the bank covers the full or the remaining amount on behalf of the buyer.

While sanctioning the letter of credit limits for the purchase of raw materials, the banker has to collect the following particulars:

(a)Value of raw materials consumed in the ensuring year as projected

(b)Value of raw materials that are purchased on credit out of the above

(d) Time for shipment and the consignment to reach the customer’s destination

(e) Credit period (usance period) agreed between the beneficiary and the customer

(f) Credit period projected and reckoned for calculation of the maximum permissible bank finance (MPBF) while sanctioning the funded limits to the borrower customer

Example:

Value of raw material consumption projected: Rs 3600 lakhs

Value of raw material (to be) bought on credit: Rs 2400 lakhs

Time for advising L/C: 10 days

Shipment time: 20 days

Credit period agreed upon between the seller and the customer OR the credit period projected as available in CMA format considered for calculation of MPBF while sanctioning funded limits, whichever is less: 30 days

Time required for one cycle of operation of L/C will be 10+20+30= 60 days

Assuming 360 days in a year, there could be 6 rotations/ cycles in a year. If the raw material consumed, to be bought on credit is Rs 2400 lakh in a year, the limit of L/C per rotation/cycle will work out to.

2400lakhs/6=400 lakh

Underwriting and credit guarantee:

Besides the above non-fund based facilities, some banks also do underwriting and credit guarantee business. The risk under this activity involves the obligation of the banker to provide funds or pay, in the event of the failure of the borrower to raise money, or to repay money. After the advent of merchant banking, this type of lending by commercial banks is on the decline.

Derivative products:

In addition to the above mentioned traditional non-fund facilities, banks are now increasingly offering the derivative products to their clients to enable them to hedge their currency and interest rate risks. As these products carry financial exposure on the customers these are nonfund based credit support to the customers.

Types Of Borrowers

Various borrowers can be classified as follows:

Individual
Proprietorship Firm
Partnership Firm
Hindu Undivided Family
Companies
Statutory Corporations
Trusts and Co-operative Societies
Limited Liability Partnerships

Individual

Banks can lend to all eligible individuals of sound mind who are not minors.

Minor Individual: a minor is not capable of entering into a contract and a contract entered into by a minor is void. The only exception recognised is of supply of necessities to him. Section 68 of the Indian Contract Act says that the property of a minor is liable for such loans. Guardians may borrow on behalf of the minors.
Not of sound mind: If a person is not of a sound mind, then he is incompetent to enter into a contract as per Section 12 of the Indian Contract Act, 1872.
Disqualified person: The contract entered into by such a person is not enforceable as per Section 11 of the Indian Contract Act.
Married Woman: Law does not debar a married woman to seek advance from a bank. She must have independent means and borrowings should be commensurate with her requirements and her ability to repay.
Pardahnashin Woman: She is qualified to get an advance sanctioned and has the capacity to enter into a contract.

Proprietorship Firm:

The dealings with proprietorship firms are governed essentially by the Indian Contract Act. The liability of the sole proprietor is unlimited, and the creditors would have recourse not only against the assets employed in business but also against the private assets of the proprietor.

Partnership Firm:

The Indian Partnership Act, 1932 governs a ‘Partnership Firm’.

While entertaining a loan proposal of a partnership firm, the following requirements are important:

The firm should be a registered one
To scrutinize the partnership deed for any provisions that may put the loan into a jeopardy
If one of the partners is a Limited Company, bank’s charge should be registered with ROC.

Essential Points of Partnership Firm

Two partnerships cannot enter into a partnership although all the partners of the firms may form a separate partnership, Currently as per the Companies (Miscellaneous) Rules, 2014, the maximum number is 50 for a partnership for the purpose of gain
There must be an express or implied agreement between the Partners to do a business that is legal for gain.
The business must be carried on either by all or by any of the partners of the firm. These entities are not partnership: a society, an association, a club, a joint Hindu Family, a co-ownership.

Registration of Partnership Firm

The Partnership Act does not provide for compulsory registration of firms. if the firm’s registration is not done, then the firm or any other person on its behalf cannot file a suit against a third party or against any partner of the firm, for breach of contract which the firm has entered into.
Application for registration of a firm is submitted, with in one year of forming, to the Registrar of Firms. with a statement in the prescribed form, along with the fee.
Registrar records an entry of the statement in the Register of Firms, files the original statement, and grants the certificate of registration.

Business of Partnership Firm

Section 19 of the Indian Partnership Act, 1932 states that a partner cannot affect the transfer of immovable property of the firm unless expressly authorized or all the partners jointly create mortgage.
On receiving notice of insolvency of the firm, any further transactions in the account must be immediately stopped irrespective of the account being in credit or debit.
If at the time of insolvency of one of the partners, the firm’s account is in credit then the other partners can operate the same.
The death of a partner dissolves the partnership firm. Hence upon receipt of such information, bank should stop the transactions in a running credit facility like cash credit/ overdraft to crystallise the liability of the deceased partner

Hindu Undivided Family

The senior most male member of the family (called ‘Manager’ or ‘Karta’) is entitled to manage the family properties. Upon the death of the Karta, a male coparcener can become a Karta.
In the absence of any male member or if all male member(s) is/are minor; a Hindu female member can become Karta/manager of HUF.
The liability of the ‘Karta’ is unlimited, whereas the liability of the co-parceners is limited to their shares in the joint family estate.
The application to open an account must be signed by all the members and all adult members should be made jointly and severally liable for any borrowings or the account being overdrawn.

Companies

A company is a juristic person created by law (Indian Companies Act,1956 – modified in 2013), having a perpetual succession and is distinct from its members.
The shareholder’s liability is limited to the nominal value of the shares held.

Basic Law Governing Companies

CA 2013 provides that a company may be formed for any lawful purpose by 7 or more persons for public company; by 2 or more persons, for a private company; and by 1 person for One Person Company.
CA, 2013 provides on the basis of documents and information filed with the Registrar, within whose jurisdiction the registered office of a company is proposed to be situated, it shall register all the documents and information in the register and issue a certificate of incorporation.
In July 2019, CA 2013 providing that a company having a share capital shall not commence any business or exercise any borrowing powers unless a declaration is filed (within 180 days of the date of incorporation) by (a) director with the Registrar that every subscriber to MoA has paid the value of the shares agreed to be taken by him; and (b) The company has filed with the Registrar a verification of its registered office.

Statutory Corporations

There may be corporations established by an Act of Parliament. These are called ‘Statutory Corporations’. For example, State Bank of India is established under State Bank of India Act, 1955.

Trusts & Co-operative Societies

In the case of lending to societies a banker should study the bye-laws, rules and regulations applicable to them and ascertain the legality of lending
Trusts are governed by the Indian Trusts Act, 1882, if they are private trusts and by Public Trusts Act if they are public trust, or Religious and Charitable Endowments Act, if they are trusts of Hindus, and in the case of Muslims they are governed by Wakf Act.
Banks may consider taking the following indicative list of documents while opening Trust accounts: Registration certificate 2. Trust deed 3. Permanent Account Number or Form No.60 of the trust 4. Documents relating to beneficial owner, managers, officers or employees, holding an attorney to transact on its behalf.

Limited Liability Partnership

A limited liability partnership is a body corporate formed under the Limited Liability Partnership Act, 2008.
LLP shall have at least two designated partners, of whom at least one must be resident in India. The LLP is a separate legal entity, is liable to the full extent of its assets. Liability of the partners is limited to their agreed contribution in the LLP.
Small Limited Liability Partnership means a limited liability partnership— (i) the contribution of which, does not exceed Rs. 25,00,000/- and (ii) the turnover of which, for the immediately preceding financial year, does not exceed Rs. 40,00,000/-.
Bank may consider taking the following indicative list of documents for opening an account for LLP: (i) Certificate of incorporation of LLP, (ii) PAN of LLP, (iii) Registered office address proof, (iv) PAN and address proofs of all partners of the LLP, (v) LLP agreement, (vi) Any other document as specified by bank.

Types Of Credit Facilities

Working Capital

The term working capital denotes the requirement of the money by a manufacturing enterprise for financing of its day-to-day requirements.
the working capital funding required by an enterprise keeps fluctuating.
There are two concepts of working capital:
Gross working capital
Net working capital
A firm should have adequate working capital. An increase in the ratio of current assets to total assets will result in a decline in the profitability of the This is because investment in current assets is less profitable than those in fixed assets. However, an increase in this ratio would decrease the risk of the firm becoming technically insolvent.

Difference between Term Loan and Working Capital Loan

Term Loan	Working Capital Loan
Term loan is a form of borrowing where the payments can be made over a predetermined period of time in regular intervals.	Working capital loan is a loan taken out to finance routine business operations to minimize shortfalls in working capital.
Term loans may be short, medium or long term.	Working capital loans are short term loans. (Quarterly and Half Yearly)
Repayment of a term loan is done by many installments.	Repayment of a working capital loan is done by a limited number of installments.
The amount of the loan is based on the cost of running the business, since such loans are customized in accordance with the regular expenses incurred to run a business.	Covers high-cost investments like business expansion, purchase of expensive plant and machinery, etc.

Cash Credit and Overdraft

The cash credit facility is most prevalent mode of lending for working capital where the bank finance is regular source of funding.
Overdraft account on the other hand is a preferred mode where the need for bank finance for working capital is intermittently felt.
They also offer the customer the flexibility of drawing only such amounts as required and when required. This effectively reduces the cost of borrowing for the borrower as the interest is charged on the actual amount drawn on day to day basis.
The drawing power is determined from the market value of current assets less margin amount at the prescribed rate.
The contract of cash credit or overdraft can be express or implied.
The bankers, to avoid the rule in the Clayton’s case agree on the method of appropriation and treat all debits as one debt.
Bank not to terminate overdraft facility without notice.

Bill Finance

This facility finances directly the receivables of the borrower on individual sale transaction basis.
the bill finance is conducted through discounting of bills of exchange drawn by the borrower or third persons on the customers of borrower. The loan extended to the borrower is liquidated when the buyer of the borrower pays the discounted bill.

Bill Discounting

Usance bills drawn by the borrower on the buyer are discounted by the bank and the amount of the bill less discount and charges is paid to the borrower. The proceeds from the discounted bill are credited to the cash credit/ overdraft account of the borrower. When the bill is paid the amount outstanding in the bills discounted account is cleared.

Bill purchase

Demand bills drawn by the borrower on the buyer are purchased by the bank and the amount of the bill less bank charges is paid to the borrower. These are used when the payment terms for the sale of the borrower is on immediate basis i.e. there is no credit period.

Advance against Bills for Collection

In this mode of bill finance, instead of extending finance for each individual bill separately, cash credit or overdraft facility against bills under collection is extended. The drawing power is determined based on the total amount of bills under collection less the margin amount.

Drawee bill acceptance

This is a reverse of receivable financing. The bank of the buyer pays the amount of bill drawn on the buyer to the seller’s bank/ the seller, immediately on acceptance by the buyer. On due date, the advance is liquidated by the payment made by the customer against the bill that is credited to the cash credit/ overdraft facility account.

Bills co-acceptance

This is a non-fund based facility, in which the banker adds its co-acceptance to the bills accepted by the borrower. This, therefore, acts as a bank guarantee or letter of credit for the seller providing additional comfort on credit sales.

Term / Demand Loans

Term/ Demand loans are granted to customers generally for meeting the capital expenditure needs of the business.
Term loans are granted in one lump sum (or sometimes a few tranches over a period) and are allowed to be repaid over a period in installments. Demand loans are those which are repayable on demand and is to be repaid as per a repayment schedule, as agreed upon by the bank.
Term loans are classified into:

(i) Short-term Loans

(ii) Medium-term Loans

(iii) Long-term Loans

The limitation period for filing a suit in the case of term loans is three years from the date of default of a particular/specific instalment. Besides, the bank is entitled to wait until the due date of the last instalment and then institute a suit for recovery of whole amount.
In the case of a demand loan the time limit is three years from the date of default.

JAIIB PPB Module B Unit 1 Principles of lending, Different types of borrowers & Types of credit facilities (Ambitious Baba) PDF