Lending is an important activity of the banking industry. Bank invests public deposits in the form of lending and earns a profit. The quality of the advances indicates the bank’s image in the market. A banker should have a thorough knowledge of the requirement of the customer and should be in a position to cater to the needs of the customer. A credit facility is an agreement with the bank that enables a person or organization to take credit or borrow money when it is needed. The business of lending is carried on by the bank by offering various credit facilities to its customer. Based on security bank credit can be classified into two types.
- Secured Advance: The advance which is secured by primary or collateral security is called Secured Advances. In the event of a loan default, the lender can take possession of the asset and use it to cover the loan. e.g.Business loan, housing loan, etc
- Unsecured Advances: Unsecured advances don’t have assets either primary or collateral. These are also called clean advances. Unsecured loans rely solely on the borrower’s credit history and his income to qualify for the loan. e.g.- Credit Card, Clean personal loan, Education loan (small), etc.
All types of credit facilities may be classified into two groups based on fund outflow:
1. Fund Based Credit
2. Non-Fund Based Credit
1. Fund Based Credit: Fund Base Credit is the credit facility that involves the direct outflow of the Bank’s fund to the borrower. Various types of Fund Based Credit facilities are as follows:-
A) Loan: A term/demand loan is simply a loan provided for meeting the capital expenditure need & business purposes that need to be paid back within a specified time frame along with interest. Loans are given for the purchase of machinery, equipment, or any fixed assets for starting a business or fulfilling personal needs. Repayment Schedule, period of the loan, mode of disbursement, rate of interest & other terms are predetermined terms.
The loan which is repaid for up to three years is called ‘Demand Loan’ & If the repayment schedule is more than three years is called ‘Term Loan’. Loans can be classified into three types based on repayment period:-
i. Short Term Loan: Usually short-term loans are repayable within one year.
ii. Medium Term Loan: It is generally repayable between one and three years.
iii. Long Term Loan: It is repayable in more than three years.
B) Cash Credit: For running the business, a borrower needs working capital to meet day-to-day expenses, Stock, and book debt. It refers to a credit facility in which borrowers can borrow any time within the agreed limit for a certain period for their working capital need. It is a running account facility where credit and debit both are permitted. It is secured by way of Hypothecation of Stock (goods), Debtors (Book Debts), and all other current Assets of the business generated during the business. Cash credit can also be secured by way of mortgage of immovable properties (as collateral security).
C) Over Draft: An overdraft allows a current account holder to withdraw more than their credit balance up to a sanctioned limit. An overdraft may be permitted without any security as a ‘clean overdraft’ for temporary periods to enable the borrower to tide over some emergent financial difficulty. ‘Secured overdraft’ facility is secured by way of Mortgage of immovable properties and pledge of F.D., Bonds, Shares securities, Gold & silver and all other current assets of the business generated during the business.
D)Credit Card: Credit cards serve many useful functions, including the ability to pay for purchases when you don’t have cash on hand. The credit card issuer essentially loans you the money to make the purchase, and you will be able to repay that loan at a later date while being charged a certain interest rate. The credit limit of the Credit Card depends upon the credit history and regular income of the cardholder.
E) Bridge Loan: Loans given to businesses that might need instant cash flow to finance a project. Bridge loans are normally obtained while the borrower is waiting for long-term financing to go through. These loans are repaid out of the amount of term loan sanctioned or the fund raised in the capital market.
F) Composite Loans: It is a loan that is granted for both buying capital assets and meeting working capital requirements. Composite Loans are usually given to an MSME Unit, cottage industry, artisan, farmers, etc.
G) Retail Loan: Retail loans are those loans that are given by the banks to meet personal needs, retail loans are smaller in size as compared to corporate loans. Home loans, Vehicle loans, Education loans, personal loans, Vacation purposes, medical purposes, etc are categorized as retail loans.
H) Bill Finance: Bill discounting is a major activity with some of the Banks. Under this type of lending, Bank takes the bill drawn by the borrower on his (borrower’s) customer and pays him immediately deducting some amount as discount/commission. The Bank then presents the Bill to the borrower’s customer on the due date of the Bill and collects the proceeds. If the bill is delayed, the borrower or his customer pays the Bank a predetermined interest depending upon the terms of the transaction. The transaction is practically an advance against the security of the bill which is due for payment.
I) Export Finance: Banks grant export credit on very liberal terms to meet all the financial requirements of exporters. The bank credit for exports can broadly be divided into two groups as under:
i) Pre-Shipment advances/packing credit advances: It is a credit facility sanctioned to an exporter in the Pre-Shipment stage. Such credit facilitates the exporter to purchase raw materials at competitive rates and manufacture or produce goods according to the requirement of the buyer and organize to have it packed for onward export.
ii) Post-Shipment Finance: Post shipment credit is a working capital facility granted by a bank to the exporter of goods/services from the date of extending credit after shipment of goods/rendering of services to the date of realization of export proceeds. As per the extant instructions, the maximum period prescribed for the realization of export proceeds is 12 months from the date of shipment.
2. Non-Fund Based Credit: Non-fund based facilities are such facilities extended by banks that do not involve outgo of funds from the bank when the customer avails the facilities but may at a later date crystallize into a financial liability if the customer fails to honor the commitment made by availing these facilities. These are also called Off-balance sheet (OBS) items.
Off-balance sheet (OBS) items refer to assets or liabilities that do not appear on a company’s balance sheet but that are nonetheless effectively assets or liabilities of the company. These items are not assets or liabilities to be reported in the balance sheet as on the date of the balance sheet but may get converted into an asset or liability at a later date, depending on the happening of a certain event. These items are contingent upon certain breaches of commitments and are also called ‘Contingent Liabilities’. These contingent liabilities have to be disclosed as ‘Notes to the Balance Sheet’. But once these commitments crystalize, these also become part of the assets or liabilities of the bank and have to be shown in the balance sheet.
Banks classify their off-balance sheet exposure into three broad categories:
1. Full risk (credit substitute): Standby letter of credit, money guarantees, etc.
2. Medium risk (not direct credit substitute): Bid bonds, letter of credit, indemnities and warranties, etc.
3. Low risk: Reverse Repos, currency swaps, options, futures, etc.
The banker undertakes a risk to the amount on happening of a contingency. Different types of Non-fund-based credit facility are as follow:
(i) Letter Of Credit: Letter of Credit is an undertaking issued by a bank (Issuing Bank), on behalf of the buyer (the importer), to the seller (the exporter) to pay for goods and services provided that the seller presents documents which comply with the terms and conditions of the Letter of Credit, within a specified time. The banks follow the Uniform Customs & Practices relating to Documentary Credits 600 (UCPDC 600) framed by the International Chamber of commerce. LC issued by the banker is irrevocable and shall not cancel without the consent of both the buyer and the seller.
(ii) Bank Guarantee: A Bank guarantee is a promise from a bank that the liabilities of a debtor will be met if the debtor fails to fulfill your contractual obligations. It is a promise from a bank or other lending institution that if a particular borrower defaults on a loan, the bank will cover the loss. It may be Financial Guarantee, Performance Guarantee, or Deferred Payment Guarantee.
(iii) Derivative Products: In addition to the traditional non-fund facilities, banks are now offering derivative products to their clients to enable them to hedge their currency and interest rate risks.
(iv) Buyer Credit: It is a short-term credit available to an importer (buyer) from overseas lenders such as banks and other financial institutions for goods they are importing. The overseas banks usually lend the importer (buyer) based on the letter of comfort (a bank guarantee) issued by the importer’s bank.
First, let us try to understand it from a layman’s perspective: Suppose I have to buy a certain high-end mobile phone from Delhi, but I am not able to go to Delhi, for this purpose. I live in Patna, but one of my friends Mr. Sanjay studies there in JNU. I will ask the supplier to send me the mobile and I assure him that I will make arrangements to make the payment to him through my friend Sanjay. The shopkeeper couriers the mobile to me. Sanjay pays the bill to the shopkeeper. I, in turn, send an NEFT to Sanjay’s account.
Now coming to the exact definition, to make the payment of import bills, the importer buyer, say, in India requests his banker, say, Bank of India to arrange credit for him in foreign currency from its correspondent bank, say, Bank of India in New York. Conceding to his request, Indian Bank arranges a loan to him, say, for $ 1 million from Bank of America and makes it available to the importer for making payment of import bills. Sometimes importer himself strikes a deal by negotiating with various banks to get buyer’s credit at a very competitive rate, say LIBOR+0.80 or so. Later on, the importer repays this amount either through their EEFC account, realization proceeds of export bills, etc. Such arrangements are known as Buyer’s Credit.
As the ROI of such loans is cheaper as compared to bill finance rates, nowadays, importer customers prefer to adopt the route of Buyer’s Credit instead of availing bill negotiating facility under Letter of Credit.
(v) Supplier Credit: Under such a credit facility an exporter extends credit to a foreign importer to finance his purchase. Usually, the importer pays a portion of the contract value in cash and issues a Promissory note as evidence of his obligation to pay the balance over some time. The exporter thus accepts a deferred payment from the importer and may be able to obtain cash payment by discounting or selling such promissory note created with his bank.
Let us first understand the concept from a layman’s point of view: The milkman gives us milk daily for all 30/31 days of a month, but he asks for money only at the end of the month. So all these 30 days he has been extending credit to us. Such type of credit extended by the seller or supplier to the purchaser is termed as Supplier’s Credit.
Now coming to the precise definition, such types of credit is extended by the exporter supplier to the buyer or importer of the capital goods. The terms can be a down payment with the balance payable in installments. To finance the credit given to the importer under such arrangements, the exporter raises a loan from his banker under the export credit scheme in force.