Bank Finance Regulation
Banks have been following certain norms in granting work capital finance to companies. These norms have been greatly influenced by the recommendations of various committees appointed by the reserve bank of India from time to time. The norms of working capital finance followed by bank since mid-70 were mainly based on the recommendations of the tendon committee.
Guidelines for bank finance: historical perspective
A study group, popularly known as the tendon committee, was appointed by the reserve bank of India in July 1974 to suggest guidelines for the rational allocation and optimum use of bank credit. This was done on the presumption that the existing system of bank lending had a number of weaknesses.
Bank credit is a scare resource; hence it should be optimally utilized under all circumstances. For industrial units it has become scarcer. These are many other contenders for bank credit: agriculture, small-scale industry, farmers, small man and many others. Public enterprises also approach commercial bank for their working capital requirements.
In fact, the misuse of bank funds was made possible by the existing system of bank lending, based on cash credit system. The practice was to lend generally to the extent of 75 per centof the value of inventory and receivables, the remaining 25 per cent being the margin. The value of inventory included purchases of materials on credit. Thus, this amounted to double financing-from creditors as well as banks. Bank lending, under the cash credit system, was directly related to security in the form of inventory and receivables, irrespective of borrower’s operations. So long as the borrower continued to provide the required margin, the banker considered his advance to be safe and liquid, and sis not bother about the way in which advance was being utilized. The borrower’s limit was generally increased, without mush questioning about his operations, whenever inventory and receivable levels whet up. The banker never took an closer look into the affairs of the customer.
One important drawback of the system was that the banker sanctioned a maximum limit within which the borrower could draw at his will. Under this procedure, the level of advances in a bank is determined not by how much a banker can lend at that time. Under a tight situation, such a system would put banks to considerable strain. The cash credit system makes credit planning by banks very difficult.
The deejay committee
The above-mentioned deficiencies of the existing system of bank lending, Based on cash credit system, were formally highlighted by the deejay committee on 1968. The committee concluded that the diversion of bank finance for the acquisition of fixed and other non-current assets was made possible by the banker’s fixation on security under the cash credit lending system. The committee felt that, while theoretically commercial bank lending was for short-term purposes, in actual practice, it was not so.
The tendon committee recommendations
The recommendations of the tendon committee are based on the following notions:
1. Operating plan:- the borrower should indicate the likely demand for credit. for this purpose, he should draw operating plans for the ensuing year and supply them to the banker. This procedure will facilitate credit planning at the banks’ level. It will also help the bankers in evaluating the borrower’s credit needs in a realistic manner and n the periodic follow-up during the ensuing year.
2. Production-based financing:- the banker should finance only the genuine production needs of the borrower. The borrower should maintain reasonable levels of inventory and receivable; he should hold just enough to carry on his target production. Efficient management of resources should therefore be ensured to eliminate slow moving and flabby inventories.
3. Partial bank financing:- the working capital needs of the borrower cannot be entirely financed by the banker. The banker will finance only a reasonable part of it; for the remaining the borrower should depend upon this own funds, generated internally and externally.
Inventory and receivable norms
The tendon committee made a number of important recommendations regarding the bank lending practices. But it is the recommendation regarding the inventory and receivable norms which have been debated and criticized mostly.
Another important recommendation of the committee related to the approach to be followed by commercial banks in lending credit to borrowers. The committee felt that the main function of a banker as a lender was to supplement the borrower’s resources to carry an acceptable level of current assets. This implied (a) the level of current assets must be reasonable and based on norms, (b) a part of the fund requirements for carrying current assets must be financed from long-term funds comprising owned funds and term borrowings including other non-current liabilities.
Working capital gap
Is defined as current assets minus current liabilities excluding bank borrowings. Current assets will be taken at estimated values or values as per the tendon committee norms, whichever is lower. Current assets will consist of inventory and receivables, referred as chargeable current assets (CCA) and other current assets (OCA).
Maximum permissible bank finance (MPBF) in view of the above approach to bank lending, the committee suggested the following three methods of determining the permissible level of bank borrowings:
1. First method:- in the first method, the borrower will contribute 25 per cent of the working capital gap; the remaining 75 per cent be financed from bank borrowings this method will give a minimum current ratio of
2. Second method:- in the second method, the borrower will contribute 25 per cent of the total current assets. The remaining of the working capital gap (the working capital gap less the borrower’s contribution) can be bridged from the bank borrowings. This method will give a current ratio of .
3. Third method:- in the third method, borrower will contribute 100 percent of core assets, as defined and 25 per cent of the balance of current assets. The remaining of the working capital gap can be met from the borrowings. This method will further strengthen the current ratio.