Principles of Lending & Credit Appraisal

The principles of lending and credit appraisal guide banks in deploying public funds prudently, ensuring that credit is extended in a manner that balances profitability with safety, liquidity, and economic usefulness. Together, lending principles, systematic credit appraisal, and credit rating frameworks help banks manage credit risk, maintain asset quality, and support sustainable economic growth.

Principles of Lending

The principles of lending ensure that loans are made prudently, balancing the interests of the bank (and its depositors) with the needs of borrowers. The key principles include Safety, Liquidity, Profitability, Purpose, and Diversification (sometimes called risk spread).

Safety

Safety refers to the assurance that funds lent by the bank will be repaid as agreed. It is the most important principle of lending, as bank funds largely belong to depositors. To ensure safety, banks carefully assess the borrower’s creditworthiness by analysing income, cash flows, repayment capacity, credit history, financial statements, and prevailing economic conditions. While collateral provides a secondary source of repayment, prudent lending primarily relies on the borrower’s ability and willingness to repay. Rigorous due diligence and risk assessment reduce the probability of default and protect depositor interests.

Liquidity

Liquidity denotes the bank’s ability to meet its obligations, particularly deposit withdrawals, as and when they arise. Since loans are generally illiquid assets, banks must avoid locking up excessive funds in long-term or non-repayable advances. This principle requires banks to balance long-term lending with short-term or self-liquidating loans and to maintain adequate liquid assets. Proper structuring of loan maturities and repayment schedules ensures that banks can respond to unforeseen cash demands without stress.

Profitability

Banks are commercial entities and must earn adequate profits to remain viable and expand operations. Lending should therefore generate a reasonable return, primarily through interest income. While pricing loans, banks consider the cost of deposits, administrative expenses, credit risk, and provisioning requirements. Higher-risk loans usually attract higher interest rates to compensate for the risk. The profitability principle emphasises striking a balance between competitive pricing for borrowers and sustainable margins for the bank.

Purpose

Banks examine the purpose of the loan before sanctioning credit. Lending is generally encouraged for productive, legal, and economically beneficial activities such as agriculture, industry, trade, education, and infrastructure. Loans for speculative or unproductive purposes are viewed cautiously, as they may not generate stable cash flows for repayment. Ensuring end-use of funds for the stated purpose is an integral part of credit monitoring and aligns bank lending with broader developmental and policy priorities.

Diversification

Diversification, also known as risk spread, involves distributing loans across different borrowers, sectors, industries, and regions. Excessive exposure to a single borrower or sector increases vulnerability to concentrated risk. By maintaining a diversified loan portfolio, banks reduce the impact of sector-specific downturns or individual defaults. Regulatory exposure limits prescribed by the Reserve Bank of India reinforce this principle and help maintain overall asset quality.
(In addition to the above, sometimes the Security of the loan (availability of collateral) is listed as a principle. While collateral does not replace prudent assessment of repayment ability, having security can mitigate losses if the borrower defaults. Banks evaluate collateral carefully – its value, marketability, and legal enforceability – as a fallback option for recovery.)

Credit Appraisal

Credit appraisal is the systematic evaluation of a loan proposal to assess the borrower’s ability and willingness to repay. It is a critical pre-sanction exercise that combines financial analysis, risk assessment, and qualitative judgement.

Information and Documentation

The appraisal process begins with collection of relevant information and documents. These include identity and address proofs, financial statements, income and cash flow details, bank statements, business or project reports, and details of collateral, if applicable. The borrower must clearly specify the purpose of the loan and the proposed utilisation of funds.

Credit Analysis

Once information is gathered, banks analyse the proposal to determine creditworthiness. Key aspects include:

• Repayment Capacity: Assessment of income stability, cash flows, and ratios such as debt service coverage to ensure the borrower can service the loan comfortably.
• Credit History: Review of past repayment behaviour and credit bureau records to identify defaults or overleveraging.
• Capital and Net Worth: Evaluation of the borrower’s own stake in the business or project, reflecting commitment and financial strength.
• Collateral Assessment: Verification of the adequacy and enforceability of security offered.
• Business and Project Viability: Analysis of the economic, technical, and financial feasibility of projects, industry conditions, and future prospects.
• Character and Management Quality: Assessment of integrity, competence, and track record of the borrower or management, often summarised under the “5 Cs of Credit” – Character, Capacity, Capital, Collateral, and Conditions.

Sanctioning and Terms

If the appraisal is satisfactory, the loan is sanctioned with defined terms, including amount, interest rate, tenure, repayment schedule, and covenants. The sanctioned amount may be lower than requested if cash flows do not justify the full exposure. Unsatisfactory proposals are either rejected or returned for modification.

Documentation, Disbursement, and Monitoring

Post-sanction, legal documentation is executed, collateral charges are created, and pre-disbursement conditions are fulfilled. Disbursement may be in stages depending on the nature of the loan. After disbursement, banks monitor the account through periodic reviews, financial updates, and compliance checks to detect early signs of stress.

Credit Rating

Credit rating is an independent assessment of the creditworthiness of a borrower or a specific debt instrument. It is particularly relevant for corporate borrowers and marketable debt securities.

Credit Rating Agencies and Scales

In India, credit rating agencies registered with the Securities and Exchange Board of India assign ratings using standardised symbols. Prominent agencies include CRISIL, ICRA, CARE, India Ratings & Research, Brickwork Ratings, and Acuité Ratings. Ratings typically range from AAA (highest safety) to D (default), with intermediate grades such as AA, A, BBB, BB, and B. Ratings of BBB and above are generally considered investment grade, while lower ratings indicate speculative or high-risk credit.

Role of Credit Ratings in Lending

Credit ratings supplement banks’ internal appraisal processes, especially for large corporate loans and investments in bonds or debentures. Higher-rated borrowers usually enjoy easier access to credit and lower interest rates, while lower-rated borrowers face higher borrowing costs or restricted access. Ratings also influence regulatory capital requirements, exposure limits, and investment eligibility. Downgrades act as early warning signals, prompting closer monitoring or corrective action by lenders.
For retail borrowers, credit scores serve a similar function by indicating individual default risk.
Note: Individuals are not rated by these agencies; instead they have credit scores (CIBIL score, etc.) which serve a similar purpose for retail lending. Credit scores typically range from 300-900 and help banks gauge personal loan/credit card applicants’ default risk. Higher scores mean lower risk.