Rationale of Margin in Banking

2. Selective Credit Control margin

One of the tools in the armoury of Reserve Bank of India is the selective credit control under which banks are required to prescribe a very high margin for advances against the security of certain agricultural commodities which are required for mass consumption and which are scarce in the country. Reserve Bank of India does not want to create a situation which will prompt traders to hoard these scarce commodities with the help of bank funds and so, as a policy, they prescribe a very steep margin, apart from other conditions governing such advances. This is a specific case of punitive or preventive margin stated above.

3. Margin prescribed by Textile Commissioner in his notifications

Cotton is one of the commodities coming under the purview of Selective Credit Control of Reserve Bank of India. The production of cotton is subject to wide variations due to vagaries of monsoon. Since the fortune of the textile and other industries is dependent upon the quantum of cotton grown, the variation in cotton production has serious implications. Further, it is necessary to ensure that the cotton growers receive their dues promptly and properly.

Therefore, the Textile Commissioner prescribes the levels of holding of cotton by the textile mills every year and these levels of holdings of inventories of cotton supersede the levels of holdings prescribed by the Tandon Committee Report.

The margin prescribed must be studied properly and should be applied only for the cases specifically mentioned in the notification. In all other cases, the margin prescribed under the current Selective Credit Control policy guidelines of the Reserve Bank of india will apply. In the years when Reserve Bank of India removes cotton from the purview of Selective Credit Control, the margin prescribed by the banks must be followed.

4. System margin - Margin prescribed by Tandon/Chore Committees

The Study Group for follow up of bank credit appointed under the Chairmanship of Sri P.L Tandon proposed a package of reforms in the bank credit system. One of the aspects of such reforms covered in the report was relating to the share that the borrower should marshal from his long term sources to fill up the wvrAmg azptfaf gap. it was in fnrs context that the report talks about three methods of lending. The difference between the three methods of lending lies in the quantum of funds from the long term sources that the borrower should bring in towards the working capital gap, the balance being provided by the bank.

The quantum of funds that the borrower should bring from his long term sources can be construed as the margin that the system of lending has prescribed for purposes of arriving at the Permissible Bank Finance. Such margin should arise from long term sources like own funds, long term loans, borrowed subordinated loans and retained profits.

Often the question is posed that after having prescribed a margin for arriving at the permissible bank finance, which the borrower brings from his long term sources, why do banks again stipulate a margin on the security to arrive at the drawing power? It should be understood that the margin prescribed for arriving at the permissible bank finance is the outer limit upto which the borrower can borrow, based on the peak level projections and on the projected net liquidity that the next year's operations are expected to generate. However, while arriving at the drawing power for purposes of actual drawings, banks are entitled to apply the usual security margin because regulating the actual drawings on the basis of the security offered is quite different from the outer limit that has been agreed to at the time of credit negotiation. Overall limit, drawing limit and drawing power are all different and have to be properly understood.

5. Security margin

Banks generally prescribe a margin when they deal with a customer for the first time or when an existing customer branches off into a new line in which he is a beginner or when the banker finds that the security offered is subject to wide variation in value. After all, banks take security to protect themselves from any eventual loss when the borrower is unable to repay eventhough he may be willing to repay. The security must then be realisable for the value of the advance. Therefore, as a protective umbrelia, bankers prescribe a margin depending upon the nature of the commodity and the fluctuation in value thai: they are generally found to undergo.

Further, banks prescribe a lower margin for raw materials, and a higher margin for stock in process and finished goods The reason for a higher margin for stock in process can easily be appreciated, since stocks in process are neither raw maierials nor finished goods. But the reason for a higher margin for finished goods than for raw materials is that raw materials can be generally made use of for several purposes whereas the finished goods have taken a definite shape, and, in the event of the bank having to realise the advance by the sale of security, raw materials stand a better chance of fetching a good price than finished goods.

6. Participative margin - Concept of borrower's stake

It is not proper, from the point of view of orthodox banking principles, for the banks to lend all the 100% of the financial needs of any borrower, for the simple reason, that the borrower is doing the business, and, in order to establish his onus and to ensure his continued interest in the venture, he should bring in a share from his resources. This is the genesis and growth of margin as a concept. Without any stake in the business, the borrower will have nothing to lose, and, so the margin prescribed is a sort of link between the lender and the borrower. Nevertheless there are cases, where, banks do Send 100% and prescribe only a notional margin with an expectation that over a period of time, the borrower will be able to bring in the required margin. This tsdanemtfra view to encouraging certain lines of business or trade, like, say, export of certain commodities.

7. Profit and Margin

Following closely what is stated above is the question whether the banker should finance the profits of the borrowers also. Why do the borrowers need finance for the profits they are going to realise in future? In this context, issues like, at what rate the borrower should value the finished goods or should bankers prescribe a margin for financing bill transactions etc. arise. While the finished goods are to be valued at their cost of sales for purposes of computing the drawing power, thereby not allowing their profits to be included, in the case of financing bills banks very often do not prescribe any margin. Although not prescribing any margin for financing bills arising from sale of the goods manufactured can be viewed as offending the orthodox principles of insisting upon borrower's stake in any lending proposition, the rationale for bankers taking a lenient view here is that the bill has the backing of a confirmed sale order from the buyer and, further, the bills are self liquidating and quickly revolving in nature. Therefore, banks take a liberal view. Moreover, bill financing will be a part of a total package of limits, in which the other limits would carry margins and other security prescriptions which should take care of the absence of any margin for bill finance. This is the view taken by banks generally when they finance bills.

8. Margin for advances against bank's term deposits

Borrowers do not appreciate the need for a margin for advances against bank's own deposits, and, that too, at 25% as it is presently. Sometimes branch managers also do not quite see the logic. The reason for any margin prescription for such advances is that banks have to maintain the Cash Reserve Ratio (CRR) and the Statutory Liquidity Ratio (SLR) on their total demand and time liabilities. Therefore, on all the term deposits against which advances are asked for also, banks would have laid down these statutory percentages. If this aspect is understood, then the margin of 25% prescribed for such advances would appear rather low.

9. Margin for Non - fund based limits

Banks generally prescribe a margin for issuing any type of guarantee and also for issuing a deferred payment guarantee. The margin prescribed for such type of business is probably resented most by the borrowers, by contending that, after all, the banks do not lay down any funds, but only subscribe their signature and that has no bearing on the question of margin.

Margin for guarantees including deferred payment guarantees is to be prescribed on account of the following points of view.

(a) The risk element in the case of guarantees is on par with that of a term loan.

(b) The Reserve Bank of India have prescribed that the total unsecured advances of a bank plus 20% of the outstanding unsecured guarantees should not exceed at any point of time 15% of the total advances of the bank and so any margin collected for the guarantees will improve the bank's position.

(c) Guarantees are also issued for enabling the borrowers to get raw materials and so the same logic of prescribing a margin if the raw materials are obtained through direct finance from the banks by way of Cash Credit or loan should equally be applicable to the guarantees.

(d) The concept of borrower's stake in any business should hold good in the case of guarantees also.

In the case of deferred payment guarantees issued for the acquisition of capital equipments, the margin to be prescribed should be the same as for term loan. Any advance payment that the borrower may in one place, an account about all types of situations where the banks have to prescribe margin and the principles and rationale governing them. It is hoped that the branch managers would appreciate them and be in a position to explain and convince their customers and do not embarrass their sanctioning authorities with any recommendations for any dilution in margins. The issue cannot be brushed aside as marginal. It is indeed vital.