BF 430-CORPORATE & MERCHANT BANKING

LECTURE 3;

BILATERAL LOANS AND ADVANCES.

4.1 Introduction

Loans and Advances are one of the services banks offer to their corporate clients.
Lending of funds to firms, traders, businessmen and industrial enterprises (corporate
clients) is one of the important activities of commercial banks. The major part of the
deposits received by banks is lent out, and a large part of their income is earned from
interest on such lending.

There is a considerable difference between the rate of interest which the commercial bank
grants on deposits, and the rate they charge on loans and advances. It is this difference
which constitutes the main source of bank earnings.

Loans represent the majority of a bank’s assets. A bank can typically earn a higher rate of
interest on loans than on securities. Loans however, come with risk. If a bank makes bad
loans to businesses, the banks may suffer on default of repayments.

Operation and expansion of business and commercial activities depend a great deal on the
availability of loans/advances from commercial banks. In this lecture, we look at the
procedure of getting loans and advances, cash credits, overdrafts, etc from the banks.

4.2 Meaning of Loans and Advances

A loan is a sum of money borrowed by a customer or business from a bank, often

for a specific purpose. The term ‘loan’ can also refer to the amount borrowed by one
person from another. The amount is in the nature of loan and refers to the sum paid to the
borrower. Thus from the view point of borrower, it is ‘borrowing’ and from the view
point of bank, it is ‘lending’. Loan may be regarded as ‘credit’ granted where the money
is disbursed and its recovery is made on a later date. It is a debt for the borrower. While
granting loans, credit is given for a definite purpose and for a predetermined period.
Interest is charged on the loan at agreed rate and intervals of payment.

1
 An ‘Advance’ on the other hand, is a ‘credit facility’ granted by the bank. Banks grant
advances largely for short-term purposes, such as purchase of goods traded in and
meeting other short-term trading liabilities. There is a sense of debt in loan, whereas an
advance is a facility being availed of by the borrower.

However, like loans, advances are also to be repaid. Thus a credit facility- repayable in
instalments over a period is termed as loan while a credit facility repayable within one
year may be known as advances. However, these two terms are used interchangeably.

4.3 Utility of Loans and Advances

Loans and advances granted by banks are highly beneficial to companies. The growth and
diversification of business activities are effected to a large extent through bank financing.
Loans and advances granted by banks help in meeting short-term and long term financial
needs of business enterprises.

We can discuss the role played by banks in the business world by way of loans and
advances as follows:-

(a) Loans and advances can be arranged from banks in keeping with the flexibility in
business operations. Business houses may borrow money for day to day financial needs
availing of the facility of cash credit, bank overdraft and discounting of bills. The amount
raised as loan may be repaid within a short period to suit the convenience of the
borrower. Thus business may be run efficiently with borrowed funds from banks for
financing its working capital requirements.
(b) Loans and advances are utilized for making payment of current liabilities, wage and
salaries of employees, and also the tax liability of business.
(c) Loans and advances from banks are found to be ‘economical’ for business houses,
because banks charge a reasonable rate of interest on such loans/advances. For loans from
money lenders, the rate of interest charged is very high. The interest charged by
commercial banks is regulated by the Bank of Zambia.
(d) Banks generally do not interfere with the use, management and control of the borrowed
money. But it takes care to ensure that the money lent is used only for business purposes.

2
(e) Bank loans and advances are found to be convenient as far as its repayment is concerned.
This facilitates planning for future and timely repayment of loans. Otherwise business
activities would have come to a halt.
(f) Loans and advances by banks generally carry element of secrecy with it. Banks are duty-
bound to maintain secrecy of their transactions with the customers. This enhances
people’s faith in the banking system.

4.4 Borrowing Rate and Lending Rate

People make their funds available to the banks by depositing their ‘savings’ in various
types of accounts. In other words, bank funds mainly consist of deposits from the public,
though banks may also borrow money from other institutions and the central bank (BoZ).

Banks thus mobilize funds through deposits. On public deposits the banks pay interest
and the rate of interest varies according to the type of deposit. The borrowing rate refers
to the rate of interest paid by a bank on its deposits.

The rates which the banks allow depend upon the nature of deposit account and the
period for which the deposit is made with the bank. No interest is generally paid on
current account deposits. The rate is relatively lower on savings account deposits. Higher
rates ranging from 6% to 12% per annum are paid on fixed deposit accounts according to
the period of deposit.

Banks also borrow from other institutions as well as from the Central bank. When the
central bank lends money to commercial banks, the rate of interest it charges for lending
is known as ‘Bank Rate’.

The rate at which commercial banks make funds available to people is known as
‘Lending-rate’. The lending rates also vary depending upon the nature of loans and
advances. The rates also vary according to the purpose in view. For example if the loan is
sanctioned for the purpose of activities for the development of rural areas, the rate of
interest is relatively lower as against loans and advances for commercial/business
purposes.

3
 Similarly for smaller amounts of loan the rate of interest is higher as compared to larger
amounts. Again lending rates for consumer durables, e.g. loans for purchase of two-
wheelers, cars, refrigerators, etc. are relatively higher than for commercial borrowings.

However, the Central Bank from time to time announces changes in the interest-rate
structure to regulate the lending of funds by banks. Different rates of interest are
prescribed for various categories of advances, such as advances to agriculture, small scale
industries, road transport, etc. Graded rates of interest are prescribed for rural
(undeveloped) areas. Lower rate is normally charged from agencies selling food-grains at
fixed price through government approved outlets.

4.5 Banks lend money using different credit facilities:

(a) Direct loans,

(b) Revolving credit
(c) Cash credit,
(d) Overdraft, and
(e) Discounting of bills.
These are briefly discussed below:

(I) LOANS

Loan is the amount borrowed from the bank. The nature of borrowing is that the money is
disbursed and recovery is made in installments. While lending money by way of loan,
credit is given for a definite purpose and for a pre-determined period. Depending upon
the purpose and period of loan, each bank has its own procedure for granting loan.
However the bank is at liberty to grant the loan requested or refuse it depending upon its
own cash position and lending policy. There are different types of loan available from
banks:

(a) Demand loan, and

(b) Term loans
(a) A Demand Loan is a loan which is repayable on demand by the bank. In other words, it
is repayable at short-notice. The entire amount of demand loan is disbursed at one time

4
 and the borrower has to pay interest on it. The borrower can repay the loan either in lump
sum (one time) or as agreed with the bank.
For example, if it is so agreed the amount of loan may be repaid in suitable installments.
Such loans are normally granted by banks against security. The security may include
materials or goods in stock, shares of companies or any other asset. Demand loans are
raised normally for working capital purposes, like purchase of raw materials, making
payment of short-term liabilities.

(b) Term Loans: A term loan facility is granted for more than a year and repayment of such
loans is spread over a longer period. The repayment is generally made in suitable
installments of a fixed amount. Term loans must be repaid in accordance with a
predetermined repayment schedule. The most common methods of structuring a
repayment schedule are:

- Amortisation: repayment (in equal amounts) is spread evenly over the term of the loan
facility;
- Balloon repayment: repayment is made in instalments and the final instalment is the
biggest; and
- Bullet repayment: repayment is made in a single instalment at the expiry of the loan
facility.
Term loan is required for the purpose of starting a new business activity, renovation,
modernization, expansion/extension of existing units, purchase of plant and machinery,
purchase of land for setting up of a factory, construction of factory building or purchase
of other immovable assets. These loans are generally secured against the mortgage of
land, plant and machinery, building and the like.

- A term loan is a committed facility. The lender must advance money when asked to by
the borrower (subject to the borrower complying with certain conditions) once the loan
agreement has been executed. The lender usually charges a commitment fee.

- Usually term loans allow the borrower to draw down (borrow) the loan during a short
period after the loan agreement has been executed, called an "availability period".

5
- May allow the borrower to prepay all or part of the loan before the dates specified in
the repayment schedule. Although there may be a prepayment fee, the borrower will
save on interest.

- The advantages of a term loan facility are that the borrower can control the amount of
its borrowing and therefore how much interest it pays.

- It also has certainty of funds and a fixed repayment schedule.

- The disadvantage is that any amount repaid cannot be re-borrowed.

Commercial banks grant loans for different periods- short, medium, and long term for
different purposes.

(1) Short-term loans

Short term loans are granted by banks to meet the working capital needs of business. The
working capital needs refer to financial needs for such purposes as, purchase of raw
materials, payment of wages, electricity bill, taxes etc. Such loans are granted by banks to
its borrowers to be repaid within a short period of time not exceeding 12 months.

Short term loans are normally granted against the security of tangible assets like goods in
stock, shares, debentures, etc. The rate of interest charged on short term loans ranges
from 12% to 18% p.a, this varies from bank to bank.

Benefits of short term loans include;

- Do not usually require collateral

- Allow quick application that makes the funds available in a few days or even hours
- Require little paperwork
- Provide you with money when you feel a sudden unexpected need
- With short term loans you do not burden yourself with long term obligations
- Short term loans are available from various lenders and that is why it is possible to
find short term loans that fit your budget and lenders that offer you better conditions
Disadvantages

- Usually more expensive.

- Not secured by collateral the lender raises interest rates to cover the risk.

6
 - Before giving you short term loans the lender is likely to investigate into your credit
history and if it is excellent you will be offered short term loans with lower interest
rates.

(2) Medium term loans

These loans are granted for more than 12 months. In case of medium term loan, the
maturity generally runs more than one year but less than five.

Medium term loans are generally granted to finance heavy repairs, expansion of existing
units, modernization/renovation, and the purchase of furniture, fixtures, vehicles, and
plant and office equipment. Such loans are sanctioned against the security of immovable
assets. The normal rate of interest ranges between 12% to 20% depending upon the
period, purpose, nature and amount of the loan. Though banks may grant long term loans,
they avoid granting loans for more than five (5) years.

(3) Long term loans

Long-term loans are usually for periods longer than five years and can be longer for real
estate or equipment. These loans are used for major business expenses such as vehicles,
purchasing facilities, construction and furnishings. They also can be used to carry a
business through a depressed cycle.

(4) Mortgage term loan

A term loan can be availed by mortgaging a kind of security like home, office premises
etc. This type of loan is borrowed for longer periods of time that is 10, 15 or 20 years.
The repayment of the principal amount and interest may be fixed in nature or it may vary
over the course of repayment. The borrower may avail the revised rate of interest later
and may be benefited by saving in interest.

Characteristics of term loans;

 Time to maturity
 Interest
 Security: Term loans are always secured. Specifically the assets acquired using term loan
funds secure them. This is called Primary security. The company’s current and future

7
 assets also generally secure term loans. This is called secondary security or collateral
security. Also the lender may create either fixed or floating charge against the firm’s
assets

 Repayment Schedule. The principal amount of a term loan is generally repayable over a
period of 4 to 7 years. Typically, term loans provided by financial institutions are
repayable in equal semi-annual instalments or equal quarterly instalments

The interest burden declines over time, whereas the principal repayment remains
constant. This means that the total debt servicing burden (consisting of interest payment
and principal repayment) declines over time. The pattern of debt servicing burden differ
from one country to another. For most western economies the debt pattern is typically
amortized in equal periodic instalments.

4.6 Security for Loans

To ensure the safety of funds lent, the first and most important factor considered by a
bank is the capacity of borrowers to repay the amount of loan; the bank therefore, relies
primarily on the character, capacity and financial soundness of the borrower. But the
bank can hardly afford to take any risk in this regard and hence it also has the security of
tangible assets owned by the borrower.

The bank will usually require that the business provides some security (collateral) for the
loan, although in the case of a start-up this security often comes in the form of personal
guarantees provided by the entrepreneur.

In case the borrower fails to repay the loan, the bank can recover the amount by attaching
the assets. It can sell the assets offered as security and realize the amount. Thus from the
view point of security of loans, we can divide the loans into two categories: Secured, and
Unsecured.

Unsecured loans are those loans which are not covered by the security of tangible
assets. Such loans are granted to firms/institutions against the personal security of the
owner, manager or director.

8
 On the other hand, Secured loans are those which are granted against the security of
tangible assets, like stock in trade and immovable property.

Thus, while granting loans against the security of some assets, a charge is created over
the assets of the borrower in favour of the bank. This enables the bank to recover the dues
from the customer out of the sale proceeds of the assets in case the borrower fails to
repay the loan.

There are various types of securities which may be offered against loans granted, but all
of those are not acceptable to the banks. The types of securities generally accepted by the
bank are the following business entities:

- Tangible assets such as plant and machinery, motor-van, etc.

- Documents of title to goods, like Railway Receipt (R/R), Bills of exchange, etc.
- Financial Securities (Shares and Debentures)
- Real estates (Land, building, etc).
- Fixed Deposit Receipt (FDR)

In addition, a loan may be: bilateral or syndicated.

- A bilateral loan involves two parties, namely the lender and the borrower. Bilateral
facilities are common in the case of small term loan, revolving credit and overdraft
facilities.

- In a syndicated loan, two or more lenders each lend a proportion of the money. They
are common for larger deals where a lender may not be willing and/or able (for example,
for regulatory reasons) to lend the whole amount.

- Comparison between a bilateral loan and a syndicated loan

- Documents. The documents for a bilateral loan are simpler than for a syndicated
loan.

- Flexibility. A bilateral loan transaction is a private transaction, so the lender may be

more flexible on terms than in a syndicated loan where market precedent may need to
be followed.

9
- Confidentiality. Information provided by the borrower for a syndicated loan goes to a
number of lenders which increases the risk of leaks, whereas ongoing confidentiality
is easier to maintain in a bilateral loan.

- Obtaining consents, waivers and so on. These may be easier to obtain from a single
"relationship" lender, than for a syndicated loan where there are a number of lenders
who may change over time.

- Fees. These are often less for a bilateral loan than for a syndicated loan, where there
may be arrangement or underwriting fees to pay.

- Replacement of lender(s). A bilateral lender is unlikely to transfer its interest to

another lender (the loan would probably be refinanced instead). In contrast,
syndicated loan lenders will want to be able to transfer their interests and the
borrower may have only a limited right to prevent any such transfer.

(II) REVOLVING CREDIT;

This is a committed facility that provides a maximum amount that can be borrowed
over an agreed period. The borrower may draw down and repay advances during the
term of the credit facility. Amounts repaid can be re-borrowed.

The borrower can often select an interest period and fix the interest rate it pays over
that period for each advance it draws. At the end of an interest period, the borrower
will decide whether to repay or "rollover" the advance into a new interest period.

Rolling over an advance means the advance remains outstanding as far as the
borrower is concerned. Further advances can be drawn down at any time during the
availability period (commonly almost as long as the term of the credit facility) with
different interest periods running in parallel.

The advantage of a revolving credit facility is that it is flexible. The borrower can
draw down as much or as little money as it requires at any time, and repay
outstanding advances that are no longer required.

10
 The disadvantages are that commitment fees may be high. There may also be
restrictions such as minimum notice periods before an advance is made, or limits on
the amount that may be drawn at any one time.

(III) CASH CREDIT.

Cash credit is a flexible system of lending under which the borrower has the option
to withdraw the funds as and when required and to the extent of his needs. Under this
arrangement the banker specifies a limit of loan for the customer (known as cash
credit limit) up to which the customer is allowed to draw.

The cash credit limit is based on the borrower’s need and as agreed with the bank.
Against the limit of cash credit, the borrower is permitted to withdraw as and when
he needs money subject to the limit sanctioned.

It is normally sanctioned for a period of one year and secured by the security of some
tangible assets or personal guarantee. If the account is running satisfactorily, the limit
of cash credit may be renewed by the bank at the end of year. The interest is
calculated and charged to the customer’s account.

Cash credit, is one of the types of bank lending against security by way of pledge or
hypothetication of goods. ‘Pledge’ means bailment of goods as security for payment
of debt. Its primary purpose is to put the goods pledged in the possession of the
lender. It ensures recovery of loan in case of failure of the borrower to repay the
borrowed amount.

In ‘Hypothecation’, goods remain in the possession of the borrower, who binds

himself under the agreement to give possession of goods to the banker whenever the
banker requires him to do so. So hypothecation is a device to create a charge over the
asset under circumstances in which transfer of possession is either inconvenient or
impracticable.

11
(IV) OVERDRAFT.

Overdraft facility is more or less similar to ‘cash credit’ facility. Overdraft facility is the
result of an agreement with the bank by which a current account holder is allowed to
draw over and above the credit balance in his/her account. It is a short-period facility.
This facility is made available to current account holders who operate their account
through cheques. The customer is permitted to withdraw the amount of overdraft allowed
as and when he/she needs it and to repay it through deposits in the account as and when it
is convenient to him/her.

Overdraft facility is generally granted by a bank on the basis of a written request by the
customer. Sometimes the bank also insists on either a promissory note from the borrower
or personal security of the borrower to ensure safety of amount withdrawn by the
customer. The interest rate on overdraft is higher than is charged on loan.

An overdraft (or working capital facility) is for solving short-term cash flow problems. It
is generally an uncommitted facility. This means that the lender (which may be a bank or
other financial institution) has discretion whether to lend, even after the overdraft facility
agreement has been executed. They are usually repayable on demand, making them
unsuitable for certain purposes, such as funding a major acquisition. The lender will not
generally call in the overdraft unless the borrower's financial position or activities give it
cause for concern.

The following are some of the benefits of cash credits and overdraft:-

i. Cash credit and overdraft allow flexibility of borrowing, which depends upon the
need of the borrower.
ii. There is no necessity of providing security and documentation again and again for
borrowing funds.
iii. This mode of borrowing is simple and elastic and meets the short term financial
needs of the business.

Disadvantages of overdrafts include;

- Lack of certainty about whether the lender will lend and when the lender will demand
repayment.
- Lender charges may be high.

12
 - The lender usually uses its standard form document so the borrower has little scope
for amendment.
- Only a limited amount may be borrowed.
- The borrower may have to reduce the overdraft to a specified amount for a particular
number of consecutive days from time to time (to ensure it is used only for short-term
cash flow problems).

(V) DISCOUNTING OF BILLS.

Apart from sanctioning loans and advances, discounting of bills of exchange by bank is
another way of making funds available to the customers. Bills of exchange are negotiable
instruments which enable debtors to discharge their obligations to the creditors. Such
Bills of exchange arise out of commercial transactions both in inland trade and foreign
trade. When the seller of goods has to realise his dues from the buyer at a distant place
immediately or after the lapse of the agreed period of time, the bill of exchange facilitates
this task with the help of the banking institution.

Banks invest a good percentage of their funds in discounting bills of exchange. These
bills may be payable on demand or after a stated period. In discounting a bill, the bank
pays the amount to the customer in advance i.e. before the due date. For this purpose, the
bank charges discount on the bill at a specified rate. The bill so discounted is retained by
the bank till its due date and is presented to the drawee on the date of maturity. In case
the bill is dishonoured on due date the amount due on bill together with interest and other
charges is debited by the bank to the customers account.

4.7 Procedure of granting different credit facilities;

We are aware that banks provide financial assistance to its customers in the form of
loans, advances, cash credit, and overdraft and through the discounting of bills. The
procedure of applying for and sanction of loans and advances differs from bank to bank.
However, the steps which are generally to be taken in all cases are as follow:–

13
 (I) Filling up of loan application form

Each bank has separate loan application forms for different categories of borrowers.
When you want to borrow money from a bank, you will have to fill up a loan application
form available with the bank free of cost.

The loan application form contains different columns to be filled in by the applicant. It
includes all information required about the borrower, purpose of loan, nature of facility
(cash-credit, overdraft etc) required, period of repayment, nature of security offered, and
the financial status of the borrower. A running business limit may be required to furnish
additional information in respect of:

- Assets and liabilities

- Profit and loss for the last 2 to 3 years.
- The names and addresses of three persons (which may include borrowers, suppliers,
customers and bankers) for reference purposes.

(ii) Submission of form along with relevant documents

The loan application form duly filled in should be submitted to the bank along with the
relevant documents.

(iii) Sanctioning of loan

The bank scrutinizes the documents submitted and determines the credit worthiness of the
applicant. If it is found to be feasible, the loan is sanctioned. If the loan is for K5000 or
less, normally the Branch Manager himself can take the decision and sanction the loan. In
case the amount of loan is more than K5000, the application is considered at regional or
head office level, depending on the amount of loan.

(iv) Executing the Agreement

When the loan is sanctioned by the bank and the borrower is informed about it, he will
have to execute an agreement with the bank regarding terms and condition for the amount
of loan raised.

14
(v) Arrangement of Security for Loan

The borrower will now arrange for security against the loan. These securities may be
immovable properties, shares, debentures, fixed deposit receipts, and other documents, as
per agreement.

When the borrower completes all the formalities, he is allowed to get the amount of
loan/advance/overdraft as sanctioned by the bank. In case of ‘discounting of bills’, the
bank credits the amount of bill to the customer’s account before the realization of the bill
and thus, makes available the fund. In case, the bill is dishonored on due date, the amount
due on the bill together with interest and other charges are payable by the party whose
bill is discounted.

4.8 Lecture Summary

The main activities of a commercial bank include acceptance of deposits that is

mobilisation of funds, and lending these funds to people who require it for various
purpose. On the deposits received the bank pays interest to the depositors at a specified
rate. This is known as the ‘Borrowing Rate’. When the Central bank lends money to
commercial banks, the rate of interest it charges is known as ‘Bank rate’. The other
important activity of a bank is that of granting loans and advances to the public. The rate
of interest at which commercial banks lend money to the people is known as ‘Lending
rate’. The borrowing rates and lending rates are subject to change from time to time.

There are five different ways of lending money by banks; viz. (a) Direct loans; (b)
Revolving credit (c) Cash credits; (d) Overdraft, and (e) discounting of bills. Bank loans
may also be classified into three (3) categories i.e. Short-term loan, medium-term loan
and Long-term loan. Short-term loans are granted by banks to meet the working capital
needs of business. Medium term loans and long-terms loans are generally known as
‘Term loans’. These loans are granted for more than one year for heavy repairs,
expansion of units, modernisation/renovation etc. Such loans are sanctioned against the
security of permanent, immovable assets.

15
To ensure the safety of the funds lent, banks require the security of tangible assets owned
by the owner, both in the case of short-term and term loans. Unsecured loans are those
granted against the personal security of the borrowers. There are various types of
securities which are acceptable by banks against loans and advances. For getting a loan
sanctioned by any bank, one has to apply for it with relevant documents. The bank
verifies the application and determines the creditworthiness of the applicant. If it is
feasible, the loan is sanctioned. After the sanction of loan the borrower has to enter into
an agreement with the bank regarding terms and conditions of the loan. The last step is to
arrange for the security for the loan granted by bank. After completing these formalities
the borrower is allowed to draw money against the loan.

16