Banks can act as agent of lending by means of loan, overdraft and discounting bill of exchange. Commercial banks act as agent of lending through the following ways:
1) Loan: Through loan, money is lent out to customers at an agreed rate of interest for a specific period of time. In this case, the borrower’s current account will be credited by the amount of the loan. At the same time, a loan account for the amount will be opened. The customer is required to have collateral security before he can be given loan. The customer will pay interest on the full amount he has borrowed.
2) Overdraft: Overdraft is a method of credit facility in which a customer is allowed or permitted to draw a cheque more than the amount of money in his account. For example, Don Steve has N20,000 in his account and he was granted permission to withdraw N30,000. The N10,000 difference is the overdraft. The customer pays interest on the overdraft. This type of credit facility can only be enjoyed by a current account holder.
Differences between loan and overdraft
- Collateral security is required.
- It attracts lower rate of interest.
- The money is repay able at a fixed time.
- A separate account called loan account.
- Collateral security may not be required.
- It attracts higher rate of interest.
- There is gradual deduction from the customer’s account.
- No separate account is opened.
Factors for consideration before granting loan
- Purpose of the loan: The bank will want to know the purpose or reason why a customer will need loan.
- Ability to pay back the loan: The bank is also interested to know the financial capability of the customer to repay back the loan at expiration.
- Credibility of the customer: The commercial bank will study the credibility of the customer to determine his credit worthiness.
- Source of income to repay the loan: When the loan is given out, the bank is interested in knowing the source(s) of income available to the customer to repay the loan, including the interest.
- Financial position of customer’s account: The bank will also study and analyse the financial position of the customer’s account to ascertain whether loan can be given or not.
- Total amount applied for as loan: The bank will consider the total amount of money applied for and match it with the bank’s ability to give out the loan and the customer’s ability to utilise the loan effectively and repay back at the agreed period of time.
- Provision of collateral security: The bank will require from the customer collateral security to cover the amount of loan taken. The essence of the collateral security is that in case the customer defaults, the security can be converted to settle the loan taken.
- Provision of referees or guarantors: Guarantors or referees may be required to provide a land or security for the loan.
- Viability of the business: The bank studies the business critically to know whether the business or project is viable or not.
- Period of repayment of loan: The bank is interested in knowing how long it will take the customer to repay back the loan given.
3) Discounting bill of exchange: Banks can provide credit facilities to customers by discounting bill of exchange. Creditors can be paid at once and the debtor is allowed a period of credit. The bank will collect the debt when it is due for repayment. When a bank discounts a bill of exchange for a customer, it is making a payment to the creditor whose debtor has promised to pay at some future date. Thus, the bank allows the creditor to be paid at once and it will collect the debt when it is due for payment.
WAYS BY WHICH COMMERCIAL BANKS CREATE CREDIT OR MONEY
Credit or money creation refers to the process whereby commercial banks make it possible for more deposits to be made through loans or overdrafts. Bank lending in form of loan or overdraft increases the quantity of money in circulation, which in turn increases the purchasing power of the people. This is because the bank credits the amount borrowed thereby creating new bank deposits. The total purchasing power increases by the amount loaned out. This is why it is said that bank lending creates credit or money.
Commercial banks can create money or credit in the following ways:
- By granting loans to members of the public and charging interest on them. By so doing more money is pumped into circulation and this increases the purchasing power of the people.
- By granting overdraft to customers having current account. This process of overdraft permits customers to draw money above the amount in their current account up to a certain limit and interest is charged on the overdraft. (An overdraft is defined as the excess amount which a customer is allowed to draw over the amount he has in his current account). Commercial banks use current account as the basis for creating credit or money.
- Commercial banks are required by law to keep certain percentage of their deposit with the central bank known as cash ratio or liquidity ratio or cash reserve. This is done in order to protect customers’ accounts and prevent bank crisis. When the percentage of the cash reserve is low, it will enable the commercial banks to give out loans and overdrafts thereby creating credit or money but when the percentage of cash reserve is high, commercial banks will find it difficult to lend out money.
- Commercial banks can create credit or money by purchasing treasury bills from the government and by discounting bills of exchange.
It should be noted that for commercial banks to be able to create credit the following assumptions must be made.
- That no single bank can create credit except all the banks or the banking system is involved.
- That no excess reserve exists.
- There must be no cash drain from the banks.
- That the banks invest only in loans, overdrafts and purchase of treasury bills from government.
- That there must be only one type of demand – demand deposit.
LIMITATIONS TO CREDIT CREATION BY COMMERCIAL BANKS
- Cash deposit ratio: The higher the legal reserve requirements, i.e. the higher the cash deposit ratio, the lower the ability of commercial banks to create money.
- Collateral security available: If collateral security is not available, banks will be scared of lending, hence the lower the volume of money created.
- Central bank’s restrictions: Central bank’s action to restrict lending, e.g. open market operation and directives can affect the ability of commercial banks to create money.
- Amount of cash drain from the banking system: The more the amount of cash drain from the banking system, the less the amount of cash available with banks, e.g. when people borrow money and spend it on consumption.
- Interest rate charged: The higher the interest rate charged by commercial banks, the lower the rate at which customers will take loans and consequently the lower the ability to create money and vice versa.
- Willingness of other banks to lend to the public: The higher the willingness of other banks to lend to the public, the greater the ability of commercial banks to create money.
- Willingness of the public to take bank loans: Commercial banks are able to create money when the public are willing to take bank loans and overdrafts, i.e. existence of borrowers.
- Desire of the people to save: When people save, deposits are created and it is from these deposits that banks give out loans. So, the more people save, the more banks are able to create credit or money and vice versa.
PROBLEMS OF COMMERCIAL BANKS IN NIGERIA
- Urban concentration: Majority of the commercial banks are located in urban centres thereby denying the rural areas banking services.
- Low savings: Majority of the populace are poor and this leads to their inability to save in commercial banks.
- Corruption: There is a high level of corruption in the banking industry as some bank managers and officials embezzle money and grant unathorised loans to friends and relatives because of their selfish interest.
- High level of illiteracy: High level of illiteracy among the people makes banking operations and services very difficult.
- Government’s frequent interventions: Government’s frequent interventions in the operation of banks sometimes make things difficult for commercial banks to operate smoothly and efficiently.
- Low patronage: Commercial banks are not patronised as it should be as a result of ignorance, poverty and Illiteracy.
- High interest rates: The high interest rate charged by banks makes it difficult for prospective customers to take loans from the banks.
- Lack of innovative banking practices: Most commercial banks are not innovative in their banking practices as customers are not given the prompt attention they desire.
- Capital shortage: Most of the commercial banks have low capital base and this makes it impossible to grant loans to prospective customers.
- Non-repayment of loans: Some customers that took loans sometimes fail to repay the loans and this has led to the collapse or failure of some commercial banks.