Banks Precautionary Measures under Unstable Lending Environment - Essay Example

Banks precautionary measures under unstable lending environment Table of Contents Banks precautionary measures under unstable lending environment 0 Table of Contents 1 Bank loan as a preferred source of financing by corporate 2 Instability of loans 4 Precautionary Measures taken by banks against loan defaulting incidences 6 Recommendations 9 References 11 Bank loan as a preferred source of financing by corporate Companies are open to a wide range of choices when it comes to raising funds to finance their operations. This wide range of choices are commonly referred to as sources of finance and they include issuing of shares, retained profits, franchising, loan stock, venture capital, bank loans among others (Macmillan, 2007). Whenever a company requires extra funds, the management has to look at the various options of finance available and make a decision on the source that best suites the company’s needs. The choice of the source of finance by a company is determined by many factors among them the amount of funds required, the urgency of the funds, the duration of repayment of the funds, the risk exposure to the company, cost of funding, flexibility available to the company in case it requires additional funding among others. The company has to critically evaluate the merits and demerits of each source of funding bearing in mind the implications that the chosen source will have to the company either financially or otherwise. Banks remain an important pillar in the provision of credit facilities to companies because they hold large amounts of cash as their assets making it possible to provide liquidity whenever needed. This arises from the fact that banks act as financial intermediaries allowing investors with excess cash to deposit with them and at the same time making it possible for the borrows to access this funds as bank loans (Saidenberg & Strachan, 1999). Financing of company operation through bank loans is a very popular source of finance to many companies because this source of finance offers a number of advantages to the borrowing company when compared to other sources. The first advantages of bank loan as a source of finance is that loan interest paid by the company for the loan acquired is tax deductible. The interest paid by the borrower to the bank represents the cost of this particular source of finance. It is treated as a deductable expense in the profit and loss statement and as such gives rise to tax savings on the part of the company. This is not the case when compared to dividends issued by the company to the .holders of ordinary shares The next advantage of bank loan as a source of finance to companies is that a bank loan offers flexibility to the company through the option of early repayment. A company can opt to clear the outstanding bank loan before the repayment period is over if and realizes that it would be more beneficial to do so. There are a number of reasons why the company would chose to do an early repayment of the loan. The first one is in instances where the company can obtain some other cheaper sources of funding. It may be that the company has enough profits that it has retained and may want to utilize them or it may be open to another bank loan with a cheaper interest rate and as such it would be advantageous to repay the current loan and seek the alternative source of finance. The other reason for early repayment may be that the company no longer needs the funds and therefore it would be economically prudent to repay the loan and save on future interest payment. It’s however important to note that early loan repayment attracts a charge from the bank and therefore it is important to ascertain that this charge is lower than the amount of future payments in the form of interest (Danielson Scott, 2004). The third advantage of bank loans is that this source does not lead to an altered ownership structure of the company. A bank loan gives rise to a contractual obligation on the part of the borrower to pay interest and part of the principle amount advanced to it as and when it falls due. The loan is not a means to ownership of the company by the bank and as such it neither becomes a part owner neither does it play a part it the management of the companies affairs. This is very important in the choice of the source of finance especially where the shareholders of the company do not want their control of the company diluted by have a source of finance that brings in new owners like in the case of issuing shares. The next advantage of bank loan to companies is that it allows the company to plan its finances especially where the loan is a fixed interest rate loan. The company has a definite time to make the repayment of the loan as well as the interest. The calculation of the amount to be paid in terms of principle repayment and the interest is fairly easy to calculate and this helps the company to plan on the future cash outflows as well as its financial obligations (Pour, 2011). Another advantage that bank loans offers to companies as a source of finance is that bank loan is fairly easily accessible and available. A company can apply for a short term bank loan and so long as it means the basic qualification requirement, the loan will be available to the company within a short term. Owing to the fact that banks deal in cash as their principle assets, it is highly unlikely that a bank will lack funds whenever a company requires a loan. This is not the case in other sources of finance like in floating of shares as there have been instances whereby all the shares floated are not taken by investors making the company to fall short in raising the required funds (Saidenberg & Strachan, 1999). Instability of loans In their day to day operations in the unstable environment, banks are faced with instability in regards to their ability to lend loans. Due to the problem of information asymmetries, investors and firms have no information about the loans to borrow at a relatively low risk. Most brokerage firms, agents and private investors do not disclose all the details especially on risks and returns and thus pose a major threat as the uninformed investor ends up investing in risky investments and gaining lower returns. Banks has access to a lot of information gathered due to interactions with many firms in the corporate level. This problem of unawareness from the either the investors or even firms have posed a threat as they lack professional advice on when, how or who to borrow from. They are also at a risk of the brokers or any other intermediary in the financial market using their confidential information for their own benefit and this could lead to a collapse of the firm in the long run. The illiquid nature of debt securities as compared to the liquidity of the loans has also brought about instability. Banks are financial intermediaries that have the ability to offer a large pool of funds to their borrowers at any time An investor may hold debt securities which are illiquid in nature instead of using the guaranteed government securities that are un priced and highly un risky. Banks face the instability due to the liquidity level thus increasing the income effect. When firms use another intermediary rather the bank like the brokerage firms or the agents to trade their securities in the stock market, they are assured of giving a fee as a result of this, yet the broker does not guarantee security in case of a risk or even low returns (Villamil, 2008). The investor is exposed to risks. This is instability as they cannot be in a position to enjoy the concept of Irrelevance Proposition which dictates that value of the firm will remain unaffected by the risks and returns if they happen to occur. Banks are facing instability due to the high risk of defaulting into payment of loans acquired. The main reasons that the bank puts into consideration when it is determining the credit loss is the probability of the borrower refusing to pay the amounted loss that the bank will suffer in the event that the borrower does not process the full amount borrowed. The credit risk assessment for the entire firm is thus being conducted by banks and this is by grouping the firms into various categories by their level of risk and this generally referred to as credit risk analysis. Banks have offered loans which are carrying less risk as opposed to the debt securities. The bank deliver delegated monitoring in the sense that it monitors collectively all the investors and ascertains that they are not in the exhorted by those who trade on their behalf in this case the brokers. To a greater extent, the investors feel secure as they are not exposed to unwanted risks like in the case of those trading in capital markets. Through relationship banking, banks have maintained the continuous service of offering loans to their large customer base; banks have been able to exchange ideas with different firms during their operation (Boot & Thakor, 2000).The personal interactions have enabled banks to develop a great relationship which has enabled it to gather information from firms at a lower cost as firms have to disclose most of their information so that the bank can approve loan to be offered. With this important information, the bank is in a position to advise a firm which is willing to lend or invest its funds. Precautionary Measures taken by banks against loan defaulting incidences With the rising instances of borrowers defaulting in paying their loan as well as the accrued interest there on, it is important that banks institute precautionary measures to avoid committing their funds to non performing companies. Banks can have various measures to curb loan default from firms who borrow from them. The management should look for all available information concerning the borrowers before they disburse the loans to them as (Default, 2012) puts it. The following are measures to prevent default from loan payment. Giving early warnings – according to Veena (2011) the beginning of non repayment of loans lies in the worth of administration of credit appraisal and risk supervision of the banks. Having efficient after payout supervision and constantly monitoring loans to spot account that have probability to default will avoid non repayment. Paying attention to early indicators for default and being receptive on signals of loan worsening of the borrowers at all time. Warnings like worsening in financial and operating performance, changing industry distinctiveness as well as economic conditions. The bank should regularly review the borrower’s expenditures, statement of financial position, debtors, the cash flow statements and the income. Any suspicious item should be clearly being looked in to and measures taken. Agreeing with Yamazaki (2011) grading of assets in terms of risk will purpose to protect banks against loan default having high risk of non repayment of the loan. Some assets used by borrowers as collateral for the loan have a high risk of non performance of which is realized later by the bank. Thorough assessment of the value of the collateral should be done to ascertain the risk associated with it. This risk is used in the judgment of whether the client would be given the loan or not. Providing financial information to the borrowers – banks should avail all information to the borrower so that the borrower takes the loan fully informed. Terms and conditions of the loan agreement should be clearly explained to the borrower. Hidden charges other than the interest on the loan should be brought to the attention of the borrower. The banks should also get the information of the client with the credit regulation authority. Banks should get information, from the regulatory authority, of the shortlisted borrowers who have defaulted in the past and the credit rating of the borrowers as (McIndoe 2012) explains. This will help them identify potential and non potential borrowers. Another precautionary measure in loan repayment is to observe the operations of the borrower for the previous operating periods. Takamura (2013) asserts that banks should look in to irregularity in how the borrower operates the loan account, defaulting instances in paying other debts to other organizations, generation of losses instead of profits, lose of important customers, arrears increasing, non selling stock, high rate of turnover of employees of the borrower company, high debt financing than equity, late payment of bills for the borrower, disputes, funds diversion, changes in the management of the company and the last five financial statements of the borrower to ascertain it they are audited and for profit margins. This will prevent disbursing loan to a borrower who cannot be able to repay the loan plus the interest. Another measure according to Yamazaki (2011) is analyzing previous loans defaulted to know defaulter character. Some borrowers default no matter what prevention of default and management plan are, occasionally reviewing movement in preventing fraud is vital. Through comprehensive defaulter analysis reasons for defaulting will be discovered and this will be used in judgment of future borrowers. Communication with other organizations and government institutions will reveal more about a borrower, so it is of help to gather more information from other sources other than from the borrower and the bank itself. One of the best preventive measures against loan defaulting is use of the previous data to make future judgment on whether to give loans or not. Some reputable companies may want to borrow but have occasional fighting’s for control especially for the private owned companies. Banks should place their funds on safe and investment oriented firms which will be able to repay the loan. This will reduce the non performing funds for the bank. Preventive as it is banks should have provisions for the loans disbursed and insure them against any defaulting possibility. Upon defaulting they will be paid by the insurance company. This adds to the cost of giving the loan but it is very important in avoiding making losses upon loan default as (Veena, 2011) puts it. Recommendations It is important to know the need for transformational element to be inducted by banks while linking investors with firms (Thomas, 2008). Bridging the information gap through developing and maintaining relationships will ensure that banks not only develop loans as one of their main product but also focus on generating impact and significantly emerge as an institution with a high level of commercial soundness. The research done by banks has enabled to know the only aim should not be to ensure constant flow of funds but also to study on the causes of what may lead to their failures and work on giving an impact so as to survive in the unstable environment. Banks like any other business exist with a clear object one of which is to make profits. They operate in high risk business because their core business is tied to the well being of other business. The ability to recover the funds that they issue to borrowers as loan is affected by the operational circumstances of the borrower. If the borrower makes losses, there is a high likelihood that the loan repayment will be affected. The risky nature of the banks business should not however make the banks to be passive in their operation but rather it requires them to institute measures to deal with the risk. The above recommended precautionary measures will go a long way in helping the bank to operate with minimum fear of defaulters while at the same time continue to be a key supplier of finance to the corporate world. References Boot, A. W., & Thakor, A. V. (2000). Can relationship banking survive competition? The journal of Finance, 55(2), 679-713 Danielson, M., & Scott, J. (2004). Bank loan availability and trade credit demand. The financial review, 39, 579-600. Default. (2012). Default Prevention and Management. New York: Department of Education Default Prevention and Management. Macmillan, J. (2007). The basics of business finance. Retrieved 17 May 2013 from http://www.mcmillantech.co.uk/articles/BasicsOfFinance.pdf McIndoe, F. (2012). Determinants of loan default. Dublin: Central bank of ireland. Pour, N. (2011). Identify different sources of finance to plc: advantages and limitations. Kensington College and business & University of Wales. Retrieved on 17 May, 2013 from http://www.academia.edu/ Saidenberg, H., & Strachan, D. (1999). Are banks still important for financing large businesses? Current issues in economics and finance, 5(12), retrieved on 17 May, 2013 from http://www.newyorkfed.org/research/current_issues/ci5-12.pdf Takamura, T. (2013). A General Equilibrium Model with Banks and Default on Loans. Vancouver: Canadian Economic Analysis Department. Thomas, H. (2008). The Assets Framework: Moving Toward Transformative Transactions. Veena, D. (2011). Kakatiya University NPAs Reduction Strategies for Commercial Banks, Waranga. Villamil, A. P. (2008). The Modigliani-miller theorem. Forthcoming in The New Palgrave Dictionary of Economics, Second Edition, Macmillan Press, London, UK. Yamazaki, M. E. (2011). Precautionary measures for credit risk management in jump models. Toyonaka: Osaka university. Read More