Principles of Lending in Banking
Every advance has to pass the same six tests before sanction. Here is each one, with the example that makes it stick.
A bank lends money that is not its own. Most of it is depositors' money, and deposits must be repaid when they fall due. The principles of lending are the tests every advance has to pass before sanction so that this money comes back, on time, with a fair return.
The IIBF CCP syllabus names five: safety, liquidity, profitability, purpose of the loan and diversification of risk. Most study notes add a sixth, security. Learn all six. Questions usually describe a situation and ask which principle it tests.
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The Six Principles at a Glance
Safety
The question it asks
Will the money come back?
Typical red flag
Capacity to repay but a poor repayment record
Liquidity
The question it asks
Can the bank get its money back when it needs it?
Typical red flag
Long lock-in, or security that is hard to sell
Profitability
The question it asks
Does the loan earn a fair return over cost?
Typical red flag
Pricing that does not cover cost of funds and expenses
Purpose
The question it asks
Is the money going to a productive, lawful use?
Typical red flag
Speculative or prohibited end-use
Diversification
The question it asks
Is too much riding on one borrower, sector or region?
Typical red flag
Exposure near a regulatory or internal ceiling
Security
The question it asks
What can the bank fall back on if repayment fails?
Typical red flag
Loan justified only because collateral looks large
| Principle | The question it asks | Typical red flag |
|---|---|---|
| Safety | Will the money come back? | Capacity to repay but a poor repayment record |
| Liquidity | Can the bank get its money back when it needs it? | Long lock-in, or security that is hard to sell |
| Profitability | Does the loan earn a fair return over cost? | Pricing that does not cover cost of funds and expenses |
| Purpose | Is the money going to a productive, lawful use? | Speculative or prohibited end-use |
| Diversification | Is too much riding on one borrower, sector or region? | Exposure near a regulatory or internal ceiling |
| Security | What can the bank fall back on if repayment fails? | Loan justified only because collateral looks large |
Each Principle With a Branch Example
The examples use round, made-up figures to show how a credit officer applies each test.
- 1
Safety: the most important principle
Repayment depends on the borrower's capacity to pay, willingness to pay and the income the activity generates. Example: a trader with healthy sales asks for ₹50 lakh but their credit report shows past overdue accounts. Capacity is there; willingness is in doubt. Safety is not met until the character question is answered. If an MCQ asks for the most important principle, the answer is safety.
- 2
Liquidity: money should not stay locked up
Deposits are largely short term, so loans must come back as per a repayment schedule the bank can plan around. Liquidity also covers the assets charged: if the loan goes bad, they must be saleable for enough to cover the dues. Example: a bank weighing two securities of equal value prefers the one it can sell quickly without loss.
- 3
Profitability: banks are not charities
The bank earns interest on advances and pays interest on deposits. Study notes put the margin needed to cover administrative costs at roughly 3 to 4%. Pricing depends on the type of advance and the borrower's rating. Example: a large borrower's term loan earns a thin margin, but its current account, salary accounts and trade business add income. Customer Profitability Analysis (CPA) looks at the whole relationship, not one product.
- 4
Purpose: productive, not speculative
Loans should fund production, trade, agriculture, services or permitted consumption such as housing, education or a vehicle. Speculative and RBI-prohibited purposes are refused. Example: a working capital limit sanctioned for raw material that shows up as a transfer to a share trading account is a purpose failure, and the bank must follow up on end-use.
- 5
Diversification: avoid concentration
Concentration can be to one borrower or group, one industry, or one region. RBI's Large Exposures Framework (in force from 1 April 2019) caps exposure to a single counterparty at 20% of the bank's eligible Tier 1 capital (up to 25% with Board approval in exceptional cases) and to a group of connected counterparties at 25%. Example: with Tier 1 capital of ₹10,000 crore, the single counterparty ceiling is ₹2,000 crore, ₹2,500 crore at most with Board approval, and the group ceiling is ₹2,500 crore. Banks may also set internal sector limits.
- 6
Security: a cushion, not the reason
Security can be land, a building, gold, insurance policies, shares or just a personal guarantee. It is something to fall back on when the primary source of repayment fails. Example: an applicant offers a flat worth twice the loan, but the business shows no cash flow to repay. The proposal fails on safety; the flat does not rescue it.
Five or Six?
The IIBF syllabus line for Module A lists five principles and does not name security. Most study notes and the JAIIB-level texts list six, with security last. If a question gives five options and asks which is not a principle, read every option: an unrelated term (say, "popularity") is the answer, not security.
Situation questions on lending principles. No signup.
Terms That Travel With This Topic
- Concentration risk
- Risk of a large loss from over-exposure to one borrower or group, one purpose or industry, or one geography.
- Customer Profitability Analysis (CPA)
- Judging a customer's total contribution to the bank across all products, not each loan in isolation.
- Large exposure
- Under RBI's Large Exposures Framework, total exposure to a counterparty or connected group that is 10% or more of the bank's eligible Tier 1 capital.
- End-use
- What the borrowed money is actually spent on. The purpose principle needs the bank to check it after disbursement, not only at sanction.
How the IIBF Exam Tests This
- check_circleDescription to principle: "loan must come back as per the repayment schedule so the bank can meet withdrawals" is liquidity; "borrower has capacity but no willingness" is a safety failure.
- check_circleMost important principle: safety, not security or profitability.
- check_circleTrue or false traps: "banks never lend for consumption" is false; "adequate security alone justifies a loan" is false.
- check_circleDiversification numbers: single counterparty 20% (25% with Board approval) and group 25%, both of eligible Tier 1 capital. Older material quotes 15% and 40% of capital funds from the pre-2019 exposure norms.
FAQs
What are the principles of lending in banking?expand_more
Safety, liquidity, profitability, purpose of the loan, diversification of risk and security. The IIBF CCP syllabus lists the first five; most study notes add security as the sixth.
Which is the most important principle of lending?expand_more
Safety. A bank lends depositors' money, so the first test is whether the loan will be repaid, which depends on the borrower's capacity, willingness and income.
Is security a principle of lending?expand_more
Most texts treat it as one, but as a cushion only. Security is what the bank falls back on if repayment fails. It should never be the sole reason for sanctioning a loan.
How does diversification of risk apply to a bank?expand_more
The bank spreads lending across borrowers, industries and regions. RBI's Large Exposures Framework caps exposure to one counterparty at 20% of eligible Tier 1 capital (25% with Board approval) and to a connected group at 25%.
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