The principles of sound lending by commercial banks are:

(1) Safety of principal: The most important rule for lending/granting loans is the safety of funds. This is so because the banks earn income through these loans and advances. In case the bank does not get back the loans granted by it, it might fail. A bank cannot and must not sacrifice the safety of its funds to get higher rate of interest. Banks must ensure the creditworthiness of the borrower before lending.

(2) Marketability or liquidity: The second important principle of granting loan is liquidity. Liquidity means possibility of converting loans and advances into cash without loss of time and money. Banks are essentially dealers in short term funds and therefore, they lend money mainly for short term period. The banker should see that the borrower is able to repay the loan on demand or within a short notice.

(3) Return or Profitability: Return or profitability is another important principle. The funds of the bank should be invested in securities to earn highest return, so that it may pay a reasonable rate of interest to its customers on their deposits, reasonably good salaries to its employees and a good return to its shareholders. However, a bank should not sacrifice either safety or liquidity to earn a high rate of interest.

(4) Purpose of the loan: Before granting loans, the banker should examine the purpose for which the loan is demanded. If the loan is granted for productive purpose, thereby the borrower will make much profit and he will be able to pay back the loan. In no case, loan is granted for unproductive purpose.

(5) Diversification: ‘One should not put all his eggs in one basket’ is an old proverb which very clearly explains this principle. A bank should not invest all its funds in one industry. In case that industry fails, the banker will not be able to recover his loans. Hence, the bank may also fail. According to the principle of diversification, the bank should diversify its investments in different industries and should give loans to different borrowers in one industry. It is less probable that all the borrowers and industries will fail at one and the same time.

(6) Security: A banker should grant secured loans only. In case the borrower fails to return the loan, the banker may recover his loan after realizing from the sale of security. In case of unsecured loans, the chances of bad debts will be very high. Security conditions are different in different banks.

(7) Margin Money: The banker must properly value the security against which loan is granted. There must be sufficient margin between the amount of the loan and the value of the security. If adequate margin is not maintained , the loan might be unsecured in case the borrower fails to pays the principle and the amount of the interest.

(8) National Policies: Banks have certain social responsibilities towards society also. The banks have to take into account the economic and social priorities of the country beside safety, liquidity and profitability. While formulating the lending policy, the banks are guided by the government policies in relation to disbursal of credit. Thus, national interest and policies are influence the lending decisions of banks.

In conclusion, it may be said that due consideration of all the principles are necessary, while evaluating a loan proposal.