40 Commercial Banks and SMEs

Vishal Kumar

1. Learning Outcome

After completing this lesson, you will be able to:

Understand the objective of commercial banks for financing SMEs
Understand the fund based and non-fund based facilities of the banks for SMEs
Know about the principles of lending for SMEs
Understand the problems faced by banks in financing small scale entrepreneurs

2. Introduction: The Indian Financial System today consists of an impressive network of banks and financial institutions and wide range of financial instruments. Indian banking is an active participant in reshaping deregulated environment of Indian economy. The banks initiated a number of measures to respond to the changed environment of economy in addition to their traditional banking services to fulfill the newly emerging demands and aspirations of the small scale industries. The banks have introduced various innovative financial products and services like venture capital finance, factoring, lease financing, loan syndication and other merchant banking services etc. for providing financial support to SSEs. Banks play a significant role in the development of a country. Indian banking has contributed the economic development in the last seven decades in an effective way. A sound banking system is indispensable in the modern economy. Now banks have not only plays a role of financial intermediaries engaged in the mobilization of resources and lending them to industry, rather they acted as an agent of change in the Indian economy. The extent of services offered differs from bank to bank, depending upon the size and type of bank.

3. Loan Advancing Schemes of Commercial Banks to Small Business: Bank loans can be advanced through following different schemes to small scale industries:

(A) Fund Based Facilities

Many types of advances are allowed by the commercial banks in India. Demand loans are given normally for the purchase of fixed assets, whereas working capital facilities are allowed for acquiring current assets etc. Various types of fund based facilities are discussed below:

Loans: In a loan account the entire amount is paid to the business firms at one time or sometimes in instalments either in cash or by transfer to its account or by making payment directly to the supplier of goods, machinery or vehicle etc. No subsequent debit is ordinarily allowed except by way of interest and other bank charges. Loan accounts with no definite payment schedule are considered repayable on demand hence called ‘demand loans’. Where a loan is given for a specific period or term without allowing the demand character of the loan to be affected in any way, it is called ‘Term Loan’. Loans are generally granted by the banks for acquiring fixed assets. No cheque book facility is allowed in such accounts. Demand loans are also given by the banks against their own deposits, life policies, shares etc.
Overdraft: Overdraft means allowing the borrower to over draw his current balance. An overdraft account is a fluctuating or running account, the balance sometimes being in credit and at other times in debit. Overdraft facilities are generally allowed in current accounts only. For opening of an overdraft account, first of all current account will have to be opened formally.
Cash Credit: A cash credit is essentially a drawing account and the amounts may be debited or credited any number of times. Cheque book is issued to the customer to make drawing on this type of account after properly assessing the requirements of the customer and viability of the project. As the very name implies in a cash credit account, credit is given in cash. Security for such advances may consist in pledge or hypothecation of goods (raw material, stock-in-progress, finished goods etc.) or documentary bills in collection etc. Cash Credit facility as a matter of rule and practice is allowed for one year although in fact this money never comes back to bank’s basket. The demand for more and more credit limit continues for years together. Limits are to be renewed every year. Every month the borrower is required to furnish the bank, the figures of sales, purchases, stocks lying at his premises along with the life of such stocks.
Bills Purchased and Discounted: Bills are written instructions of a seller of goods to the purchaser for the payment of a stipulated amount at a particular date. It is approved by the purchaser. If the holder of the bill requires the amount of the bill before its maturity, the bills are purchased by the bank from its approved customer in whose favour regular limits are sanctioned. The bank holds a bill as security for the advance. Bills are also discounted by the banks. Bills of exchange which are discounted by the bank are debited to the Bills Discounted Account. The amount of the bill after deducting the commission is credited to the customer account. Discounting of bills constitutes a clean advance against two or more signatures of independent parties, one that of endorser and the other that of drawer.
Composite Loans: Another category of advances is also becoming popular for small advances. Under this facility, only one loan account is sanctioned for the requirements of current assets as well as fixed assets. This is called composite loans. As per RBI guidelines, such advance is usually granted to farmers, artisans and cottage and village Industries. Like other advances, advance against bills should be allowed by a banker after satisfying himself about the creditworthiness of the drawer (i.e. seller) and the genuineness of the bills. The banks should also verify the financial standing of the drawees of the bills by obtaining their confidential reports.
Consumption Loans: Normally banks provide loans for productive purposes only, but these days’ loans are also granted, on a limited scale, to meet the need for the purchase of consumer durable items, educational expenses, medical needs or, expenses relating to marriage and social ceremonies etc. Such loans are called consumption loans.
Bridge Loans: Bridge loans are essentially short term loans which are granted by the banks to industrial undertakings to meet the urgent needs during the period when sanctioning of term loans from financial institutions is in the-process or raising funds from the capital market is in the pipeline. Bridge loans are given by the commercial banks and are automatically repaid out of amount of the term loan or the fund raised in the capital market.
Export-Import credit: Banks also advances loans to finance export import business. They advance various types of loans for this purpose. Banks provide pre-shipment finance and post shipment finance to exporter.

(B) Non-Fund Based Facilities

Letter of Credit: It is an instrument issued by a bank at the request of the importer, in which the bank promises to pay a particular sum of amount to beneficiary presenting specified document in the letter of credit. Letter of credit is also known as “Commercial Letter of Credit”, a Documentary Letter of Credit; or simply a Credit. It means letter of credit reduces the risk of non-completion of the transaction. It is innovative funding mechanism for the import of goods and services on deferred payment systems LOC is an arrangement of a financing institution/bank of one country with another institution/bank to support the export of goods and services so as enables the importers to import deferred payments terms. This may be backed by a guarantee furnished by the institutions/ bank in the importing country. The LOC helps the experts to get payment immediately as soon as the goods shipped since the funds could be paid out of the pool accounts with the financing agency. It acts as conduct of financing, which is for a certain period and on certain terms for the required goods to be imported. The greatest advantages of LOC are saving a lot of time and money on mutual verifications of bonafide sources of finance etc. It serves as a source of forex.
Guarantees: A guarantee is a contract to perform the promise or discharge a liability of a third person in case of his default. The person (in this case the bank) who gives the guarantee is known as ‘the surety’, the person in respect of whose default the guarantee is given is known as, ‘the principal debtor and the person/department to whom the guarantee is given is called ‘the beneficiary’. The guarantee ‘once issued cannot be revoked without the consent of the beneficiary, before the expiry of its validity. So the guarantee though a ‘contingent liability’ in terms of balance sheet item, so a definite undertaking enforceable on the happening of a certain event (default).

4. Principles of Good Lending to Small Business

The business of lending, which is the main business of banks, carry certain inherent risks. A banker must strive to earn profit (from lending) without exposure to greater risks. Banks cannot take more than calculated risks whenever it wants to lend. Therefore, banks have to follow a cautious approach towards lending, based on certain principles. There are three cardinal principles of bank lending that have been followed by the commercial banks since long. These are the principles of safety, liquidity and profitability. These principles are inter woven and cannot be isolated. However, these principles are not exclusive and one can add more criteria for deciding advances i.e. like the purpose of the loan, the diversification of risks, the security of the loan etc. These principles should be regarded as statements of general tendencies only and not irrefutable laws, which are inelastic and incapable of wider interpretations to meet the given situation. These principles are being discussed below: –

Principle of Safety: As the bank lends the funds entrusted to it by the depositors, the first and foremost principle of lending is to ensure the safety of funds lent. Safety of funds means that whatever is lent should come back through repayment of the loan. The safety of the loan depends upon the proper selection of the borrowers, his willingness and capacity to repay back the loan taken.

Willingness to repay depends upon:

The honesty of the borrower
His integrity
His character
Fairness in dealing
Business morality
Creditworthiness of the borrower

The capacity to repay back the loan depends upon:

Viability of the project
Strengths of tangible assets of the borrower
Success of the business of the borrower

If any advance is deficient in savings, it has impact ultimately on the profits of the bank. An unsafe advance effects adversely the long-term profitability of the bank. Banks needs to ensure that the advance granted not only appears to be safe at the time it is released but continues to be safe until it is repaid. The bank, therefore, must closely watch the activities of the borrower during the currency of the advance.

After the nationalization of banks, a new direction has been given to Indian banking and to the pattern of lending in particular. Banks had to reorient their lending policies in their efforts to achieve the social objectives expected from them. Economic viability of the project has replaced consideration of security in most of the lending to the priority sectors. Production oriented lending is preferred and credit for consumption or unproductive purposes has been curbed. The need-based approach has replaced the erstwhile security based approach. In the final analysis, ta bank’s loan is safe only if it meets the production needs of the enterprise and helps in generating adequate internal cash surplus to meet the repayment. Over financing can result in overtrading, stockpiling or diversion of funds. While, underfinancing can compel the borrowers to resort to market borrowings at exorbitant rates of interest. proper appraisal of the needs of the borrowers is, therefore, necessary.

2. Principle of Liquidity: Coming back of bank’s money is not the only point to be given attention, but it is also necessary that the money should come back or repaid fairly and quickly more or less on demand. Since the bulk of funds-in which a bank deals is depositors’ money and the banker has necessarily to meet the demands of depositors. It is essential that the borrower would be in a position to repay the loan either on demand or within a reasonable period thereafter. If the money does not come back as stipulated, the bank may face a crisis of liquidity, and a mismatch of the assets and liabilities, which in turn could affect the capacity of the bank to meet its own obligations to return the money to the depositors. Hence it is not enough that money comes back but it should come back in time. Otherwise, such delay in the face of prudential guidelines on income recognition and asset classification, render the accounts non-performing.

The role of commercial banks in providing short-term, medium-term and long-term is becoming increasingly important over the years. Most of the credit extended by banks in the field of industrial finance is by way of loans payable on demand, particularly, for the purpose of working capital finance. The commercial banks do provide long-term finance for the purpose of acquisition of fixed assets. If a large part of banks’ funds is lent for a long term period i.e. for acquiring fixed assets, the ability of the bank to meet the demands of its depositors may be seriously affected. Thus it must be ensured that the money be lent for short term periods with definite repayment schedule.

3. Principle of Profitability: The commercial banks being commercial in character, have to -make profits. No commercial organisation can survive without making profits. Therefore, while making advances, the commercial banks should be guided by the consideration of an adequate return or profit. The difference between the rate at which a banker borrows from the public by way of deposits and lends money to borrowers by way of advances constitutes his gross profit. The banker, therefore, should be governed by a satisfactory margin of profit. Banks pay interest on deposits received, salary to their staff and incur other expenses for its day to day functioning.

The rates of interest charged by banks were, in the past, primarily dependent on the directives issued by the RBI. But now banks are free to determine their own rates of interest on advances of above Rs.2 lakh. The variation in the rates of interest charged from different customers depend upon the standing of the customer, the nature and value of the security, size of the advance and the degree of risk involved in lending. The general principle followed is ‘greater the risk higher the rate. Some banks rate the customers into categories A, B and C depending upon the value of their connections to the bank and their willingness to observe financial discipline and charge interest rate accordingly. In case of small industries, a progressively high rate is often charged as the amount of the-loan increases on the principle that the large borrowers are in a better position to bear heavy burden of interest.

5. Problems faced by banks in financing small scale entrepreneurs Some of the most common problems faced by banks are given below:

Banks fail to get the desired information about the character, goodwill or credit worthiness of the entrepreneur, when he approaches the bank for loan. Banks have the fear of granting loans to wrong persons resulting in delayed recovery.
Entrepreneurs are also not aware of various schemes of banks.
Small scale enterprises fail to maintain proper record of their repayment. They do not engage professionals for maintaining accounts and other records. As a result transparency in financial data is not ensured.
Lack of knowledge about the management of funds make the problem more serious at many times, the entrepreneurs divert the business funds for their personal consumption without realising its negative effects.
Increasing trend of non-performing assets acts as a strong demotivator for banks to grant loans to SSI’s.
Entrepreneur do not have sufficient knowledge of risk management techniques especially in up-coming areas like IT, biotechnology etc.
Banks do not sanction the loans if they found the project commercial un-viable.
Entrepreneurs generally do not select right project according to their aptitude and capabilities. The ignorance on their part become problem for the bank.

Summary: In this module we have discussed that Indian banking is an active participant in reshaping deregulated environment of Indian economy. The banks initiated a number of measures to respond to the changed environment of economy in addition to their traditional banking services to fulfill the newly emerging demands and aspirations of the small scale industries. The banks have introduced various innovative financial products and services like venture capital finance, factoring, lease financing, loan syndication and other merchant banking services etc. for providing financial support to SSEs. Banks play a significant role in the development of a country. Commercial banks provide short term, medium term and long term loans to small scale industries. They are playing a vital role in strengthening SMEs and MSMEs. Now banks have not only plays a role of financial intermediaries engaged in the mobilization of resources and lending them to industry, rather they acted as an agent of change in the Indian economy.

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References & Suggested Readings

Banking, Theory Law and Practice, Sundaram & Varshney, Sultan chand & sons;2004
Principles of Banking Varshney & Malhotra, Sultan Chand & Sons, 2005.
Money, Banking and International Trade, Vaish M.C, New Age International Pvt.Ltd, 1997
Banking, Theory, Law & Practice, Gordon.E, Natarajan.K., Himalaya Publishing House, New Delhi.
Banking, Law and Practice in India Banking, Tannan’s
Banking: Law and Practice P.N. Varshney
Management of Banking and Financial Services Justin Paul and Padmalatha Suresh

Points to ponder:

Bank: A bank or banker is a person, firm or company having a place of business where credits are opened by deposits or collections of money or currency or where money is advances or loaned”.
Banking: Banking means the accepting, for the purpose of lending or investment, of deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheque, draft or otherwise.
Reserve Bank of India: Reserve Bank of India is the leader of Indian Banking System. It is the apex financial institution of India. The Reserve Bank of India as apex institution organizes, supervises, regulates, runs and develops the monetary system and financial system of the country. In simple words, it controls the whole banking system in India.
Public Sector Banks: Public Sector banks are those banks which are owned and controlled by the Government of India.
Regional Rural Banks: Regional Rural Ban ks are framed to cater the need of the rural area and to fill the gap in rural credit.