PRINCIPLES OF BANK LENDING POLICY

When commercial banks consider establishing lending policies for their operation, there are several basic principles that they follow.

These principles are liquidity, safety, security diversity, stability, and profitability.

Liquidity

Liquidity means the ease with which assets can be converted into cash. 

Liquidity is arguably the uppermost consideration in bank lending because banks only make use of depositors’ money for lending, and such depositors are, of course, entitled to their money whenever they need the money. 

Given this, banks prefer to lend money for the short term because such loans are perceived to be very liquid.

They provide loans with the expectation that they will be repaid within a short time. 

Furthermore, Banks lend money based on security that is easily marketable and convertible into cash at a short notice.

They accept securities that have adequate liquidity. That is, banks accept securities that they can easily be sold at any time without incurring any significant loss

This ensures that they can meet customers' urgent needs for cash.

Safety

Because banks lend out depositors' monies, they must ensure that these loans are safe.

By "safety," we mean that borrowers should be able to pay back the loan and interest on time and at the agreed-upon intervals without defaulting.

Essentially, Borrowers' ability to repay loans depends on their ability to create sufficient funds through business entities as well as the character of such borrowers.

Furthermore, other factors like the borrowers' financial condition and the nature of collateral securities pledged for the loans can also affect repayment.

In addition to the aforementioned consideration, the banks assess the creditworthiness of the borrower which is determined by the character, capacity to repay, and financial standing of such borrowers.

While the aforementioned consideration can help determine if a loan is safe, a bank may consider a loan to be risky or unsafe if the project for which the loan is being issued is neither technically feasible nor economically viable even if it meets the aforesaid conditions. 

Diversity

When giving out loans, the banks consider the composition of the loan portfolio to strike the desired diversity.

Banks follow the popular dictum: "if you put all eggs in one basket, you risk losing them all at once". 

They do not concentrate their loan on one sector of the economy or one industry. 

Rather, they provide loans to firms and businesses in different industries and sectors of the economy. This ensures that they are not negatively affected by the failure of a single industry or sector of the economy.

Furthermore, banks diversified their loan portfolios to comply with the central bank's mandate for sectoral credit distribution.

Stability

To ensure that loans are safe, Commercial banks only lend to customers whose businesses generate stable incomes. 

For this reason, commercial banks evaluate the projects and businesses of customers who apply for a loan facility to see if they can generate consistent income to service the loan and make regular repayment.

For a new project, Bank evaluates the technical feasibility and economic viability report of such project to determine the type of cash inflows that will be used in repaying the loan and servicing it. 

In the case of an existing business, the financial reports for not less than five years on a consecutive basis will be evaluated to determine the regularity and amount of earnings. 

The purpose of this assessment is used to evaluate the stability of such earnings in terms of timely repayment of the loan

Profitability

Of course, banks do not just give loans and advances to customers just for the sake of giving them. 

Rather, they grant them to earn income. 

Banks earn income through the interest charge levied on loans granted to customers.

The interest rate on bank loans is usually determined by the prevailing market rate and the monetary policy rate set by the central bank in the economy.

To make an adequate profit, commercial banks usually charged interest rates higher than the monetary policy rate set by the central bank.

Security

Banks generally do not lend to customers without security or collateral.

This is because loans are always a risk of default and banks take security to serve as insurance against such risks.

This ensures that they have something to fall back on in case the almost certain means of repayment unexpectedly fail.

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