Lending money is one of the two major activities of any Bank. Banks accept deposit from public for safe-keeping and pay interest to them. They then lend this money to earn interest on this money. In a way, the Banks act as intermediaries between the people who have the money to lend and those who have the need for money to carry out business transactions. The difference between the rate at which the interest is paid on deposits and is charged on loans, is called the "spread".
Banks lend money in various forms and they lend for practically every activity. Let us first look at the lending activity from the point of view of security. Loans are given against or in exchange of the ownership (physical or constructive) of various type of tangible items. Some of the securities against which the Banks lend are :
Consumer durable goods
Documents of title
Apart from the above categories, the Banks also lend to people on the basis of their perceived personal worth. Such loans are called clean and the Banks are understandably cagey about extending such loans. The credit card arms of the various Banks, however, fill up this void.
Cash credit Account
This account is the primary method in which Banks lend money against the security of commodities and debt. It runs like a current account except that the money that can be withdrawn from this account is not restricted to the amount deposited in the account. Instead, the account holder is permitted to withdraw a certain sum called "limit" or "credit facility" in excess of the amount deposited in the account.
Cash Credits are, in theory, payable on demand. These are, therefore, counter part of demand deposits of the Bank.
The word overdraft means the act of overdrawing from a Bank account. In other words, the account holder withdraws more money from a Bank Account than has been deposited in it.
How does this account then differ from a Cash Credit Account?
The difference is very subtle and relates to the operation of the account. In the case of Cash Credit, a proper limit is sanctioned which normally is a certain percentage of the value of the commodities/debts pledged by the account holder with the Bank. Overdraft, on the other hand, is allowed against a host of other securities including financial instruments like shares, units of mutual funds, surrender value of LIC policy and debentures etc. Some overdrafts are even granted against the perceived "worth" of an individual. Such overdrafts are called clean overdrafts.
Bill discounting is a major activity with some of the smaller Banks. Under this type of lending, Bank takes the bill drawn by borrower on his(borrower's) customer and pay 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 collect the total amount. If the bill is delayed, the borrower or his customer pay the Bank a pre-determined interest depending upon the terms of transaction.
Term Loans are the counter parts of Fixed Deposits in the Bank. Banks lend money in this mode when the repayment is sought to be made in fixed, pre-determined installments. This type of loan is normally given to the borrowers for acquiring long term assets i.e. assets which will benefit the borrower over a long period (exceeding at least one year). Purchases of plant and machinery, constructing building for factory, setting up new projects fall in this category. Financing for purchase of automobiles, consumer durables, real estate and creation of infra structure also falls in this category.
Classification of loans
Another way to classify the loans is through the activity being financed. Viewed from this angle, bank loans are bifurcated into :
Priority sector lending