Roles of Financial Institutions for Loan Settlement

This article, “Roles of Financial Institutions for Loan Settlement” is written by Suvigya Agarwal a 3rd year Law student at IFTM University.

Introduction

Financial institutions act as intermediates between lenders and borrowers, which is crucial in streamlining loan settlement procedures. Ensuring the stability and integrity of the financial system depends on these institutions operating efficiently. In this regard, knowledge of their functions in debt settlement is essential to understanding the workings of financial markets and the economy.

Financial institutions are also essential to the risk management of loan settlement. They evaluate borrowers’ creditworthiness, choose suitable interest rates and terms of repayment, and put policies in place to lessen the likelihood of defaults. These organisations protect the interests of lenders and borrowers by using sound lending practices and strong risk management systems, which promote financial stability and long-term economic growth.

Financial institutions essentially act as the cornerstones of the loan settlement process, simplifying repayment, controlling associated risks, and granting access to cash. Navigating the intricacies of borrowing and lending in the current financial environment requires an understanding of their roles.

Before we discuss the role of financial institutions in loan settlement, let us first understand financial institutions and loan settlement.

What are financial institutions?

As per the Companies Act, 2013 “financial institution” includes a scheduled bank, and any other financial institution defined or notified under the Reserve Bank of India Act, 1934 (2 of 1934) [Section 2(39)]. Financial institutions in general can be understood to be that establishment which aid people in keeping pace with their financial needs.

Classification of financial institutions

The financial institutions in India can be broadly classified into three categories:

1. All-India Financial Institutions: These are under the direct control of the Reserve Bank of India. These are key institutions to promote the flow of credit to various economic sectors. There are five All-India financial institutions, which are: 
2. Export-Import Bank of India (EXIM Bank): The regime of EXIM Bank exists in the finance and management of international trade. It provides financial facilities to exporters and importers of India. It has tie-ups with other international development banks and financial institutions to support trade and investment flows between India and other countries.
3. National Bank for Agriculture and Rural Development (NaBARD): It regulates matters which are related to economic activities in rural areas especially those that are agricultural.
4. National Bank for Financing Infrastructure and Development (NaBFID): It is an infrastructure-focused development financial institution to support long-term non-recourse infrastructure financing in India including the development of bonds and derivatives markets necessary for infrastructure financing to carry on the business of financing infrastructure.
5. National Housing Bank (NHB): It is the apex financial institution for housing which was established to promote housing finance institutions both at local and regional levels.
6. Small Industries Development Bank of India (SIDBI): It is the primary financial institution for the growth and development of the MSME (Micro, Small and Medium Enterprise) sector.
7. State-Level Institutions: These are constituted to provide financial assistance for setting up industrial projects. As the name suggests, the area of operation is limited to the state level. It comprises:
8. State Financial Corporations (SFCs): These provide long-term finance or setting up of small and medium projects within their region.
9. State Industrial Development Corporations (SIDCs): These are government undertakings to promote and develop large industries in their respective states.
10. Other Institutions: These are some special financial institutions apart from all-India financial institutions and state-level institutions such as Deposit Insurance and Credit Guarantee Corporation (DICGC) and Export Credit Guarantee Corporation of India (ECGC).

Loan

Loans is the amount of money which is borrowed from any of the financial institutions which is incurred as debt by the borrower and is to be paid back along with the interest within a given period of time.

• Types of Loans in India

There are following different types of bank loans that are available in India:

• Secured Loans

The loans which are provided against a collateral or security are known as secured loans. Inability to pay loans leads to forfeiture of the security which will lead to satisfaction of debt. The item purchased from the amount of loans can be used as collateral. Secured loans are often taken for higher loan amounts and lower rates.

Types of Secured Loans

1. Home Loan: These are secured loans that provide the debtor with funds to buy or build the home. The original documents of the property will be retained by the lender until the loan is paid off. It is usually a long-term loan.
2. Gold Loan: Loans are taken in this case against the gold kept as security. The tenure is generally short. The maximum amount that can be taken as loans depends on the gold offered as security.
3. Loan against insurance policies: A loan can be taken against insurance policies such as life insurance. In these cases, the insurance policy itself works as a collateral and therefore, no guarantee is required
4. Business Loan: These are secured loans to available money for business investment. It can be used to buy equipment or for starting a new business or to invest in projects. The collateral that can be used here is the land or building or equipment used in the course of business.

• Unsecured Loans

These are loans which do not require collateral and are given by the lender based on credibility. The interest rates are usually high due to lacks of security. A high income helps in securing such loans.

Types of Unsecured Loans

1. Personal loan: As stated above, being an unsecured loan it does not require any collateral or security. It is offered against a high-interest rate and with minimal documentation. It can be used for any personal use such as holiday planning, a child’s education or to meet any urgent unexpected expense.
2. Student loans: These are loans that are incurred by students for meeting their education expenses. These are repaid by them after they secure jobs after completing their studies.
3. Credit Cards: There are several types of credit cards but the most common are those that bill only once a month and interest is charged if the balance is not paid.

Loan Settlement

When the borrower is unable to pay the loan amount in accordance with its terms and conditions then there comes an option of loan settlement. It may be understood as the procedure of paying off loan before the tenure of the loan comes to an end. In this process, the lender is somewhat at loss in terms of the interest that he may have gained, if the loan had not settled before the original tenure. This is usually done when the borrower is no more in the condition of paying the interest on the loan. The borrower, therefore, request for loan settlement from the lender. If the lender agrees to it then he accepts a reduced one-time payment which is less than the outstanding loan amount.

Settlement of loans by financial institutions and effects of loan settlement

The financial institute which is lender on getting the knowledge of borrower’s inability to repay the loan verifies the genuineness of the claims and make it sure that the intent of the borrower is good behind it. On being satisfied, the financial institute puts forth an amount that is paid as lump-sum by the borrower. On the payment of this settlement amount, the loan stands settled.

Loan settlement is not as simple as it seems to be. We should pay attention that while the loan is settled for the borrower and technically the loan is closed, it is a deal of loss for the lender. The loss is of that amount which the lender might have got as interest if the loan would have repaid in the scheduled time of its repayment. The lender accepts the option of loan settlement only when, it is certain that the borrower cannot pay back the loan on the agreed terms and conditions. As of borrower, he is relieved from the loan at the time of loan settlement, but in long terms it is not beneficial even to him. The record of the loan being settlement affects the credibility of the borrower. It means that in future it will not be easy for him to take a loan. The settlement of loan, will the lead to a drop in the credit score of the borrower. Concisely, your image as a borrower is distorted when you settle your loan. So, loan settlement is not advisable in usual course.

Loan Settlement and Loan Closure

The two terms i.e. loan settlement and loan closure should not be confused. These are two different things with different meanings. Loan closure is done when the borrower pay off the loan as per the original terms and conditions of the loan in the scheduled tenure of its repayment. Whereas, on the other hand, loan settlement is done when the borrower is no more in a capacity to abide by the terms and conditions of the loan and the loan is repaid before the scheduled tenure. The difference between loan settlement and loan closure is as follows:

Conclusion

Above we have discussed the concept of loan settlement and the role of financial institutes in the process. Financial institutes indeed play a great role in both sanction of loan and settlement of role. As discussed above loan settlement is neither beneficial for the lender nor the borrower. Thus, it is never advisable to settle loan, and in fact go for other alternatives as far as possible.

References

1. https://rbi.org.in/upload/Publications/PDFs/58849.pdf
2. https://www.bajajfinserv.in/insights/the-different-types-of-loans-available-in-india
3. https://www.muthootfinance.com/blog/what-is-loan-settlement-how-does-it-affect-your-credit-score