Commercial banks remain the most popular financial institution globally due to the panoply of financial services they render to businesses and individuals. Among the array of financial services rendered by commercial banks, granting loans seems to stand out. People and businesses rely on bank loans for several reasons. If banks reduce their lending, many businesses and individuals will suffer. But what happens when these banks increase their lending ability?
When commercial banks increase their lending ability, they get lower interest rates. However, if they reduce their lending ability, they have to pay higher interest.
Banks have several functions. However, granting loans remains one of the most significant functions of a bank, and this is because it benefits the general public as much as it benefits banks. Below, I have put together an insightful piece regarding what you need to know about bank loans, including what happens when they hike their lending ability.
When the Lending Ability of Commercial Banks Increases?
We can correctly guess what happens when a commercial bank reduces its lending ability. Of course, many businesses will find it hard to operate, while individuals will find it difficult to make big purchases requiring loans. In this article, we won’t be talking about all these. Rather, we’ll be talking about the results of a rise in the lending ability of commercial banks. Before we talk about that, let’s look at what a commercial bank is.
What Is a Commercial Bank?
Many of us see a commercial bank as a haven for storing our money. But, there is more to a commercial bank than just a cash storage. Rather than define a commercial bank as an institution that helps safeguard our money and other valuables, here is a terse and befitting definition that clearly describes what a commercial bank is.
A commercial bank is regarded as a financial institution that receives deposits and provides financial services to its customers. These services include business loans, check account services, personal loans, mortgage loans, etc.
A commercial bank also provides financial products to its customers. And what financial products am I referring to here? Financial products offered by banks include Certificates of deposits, etc. A commercial bank is also a financial establishment that offers loans to individuals and businesses, receives deposits that are returned when demanded, and also collects and offers documents.
Having understood what a commercial bank is, why don’t we consider how it works?
How Does a Commercial Bank Work?
Have you always wanted to have a good insight into how banks work? If yes, here is your chance. Before we delve into how these banks work, let’s brief ourselves on what these banks are. Commercial banks are private financial establishments that oversee financial matters for people and organizations. These banks (which are quite common) give loans to people and organizations. They make money from interests paid on the loans provided.
A commercial bank generates profit via several means. First off, they make money from interest on personal loans (as said earlier), mortgage loans, and of course, auto loans. Apart from offering loans to people, commercial banks receive deposits from customers and issue CDs (certificates of deposits).
Individuals deposit money into savings or checking accounts that they open with commercial banks. With these deposits, commercial banks offer loans to people and, in turn, pay interest to the customers. Interest rates on loans offered and interest paid to customers are different. One is lower than the other, and I bet you know which is.
There are certain ways commercial banks make money. No, they don’t siphon people’s deposits, neither do they engage in any illegal dealings to make a profit. Instead, banks make a profit from the interests on the loans they offer to individuals and businesses,
Since banks don’t pay the same interest rates taken on loans to customers with deposits, the remaining amount is deemed revenue for the bank. Commercial banks are insured by the Federal Deposit Insurance Corp. (FDIC), and customers can withdraw their deposits easily without issues. Usually, customers’ interest on deposits in commercial banks is smaller, unlike the interest on investment products. It is also lower than the interest rates commercial banks collect on loans.
What Are Commercial Loans?
A commercial loan is a loan offered to businesses by a financial institution. Commercial loans are generally used to buy long-term assets or help fund daily operational costs.
Understanding Commercial Loan:
Small and medium-sized businesses can’t access equity and bond for financing because of regulatory difficulties, associated costs, and the time needed to obtain the funds. Thus, small and medium-sized businesses use products like commercial loans and/or lines of credit.
Commercial loans can be used for any purpose deemed fit by the business owner. It can be used to purchase assets, supplies, meet day-to-day operational costs, pay payroll, etc. In the loan application process, the business must state the purpose of the loan.
Advantages and Disadvantages of Bank Loans:
A loan is an amount of money borrowed from an entity or organization to be replayed on an agreed date. The repayment amount will depend on the loan’s size and time, including the rate of interest.
- Loans are generally most appropriate for:
- Paying for assets like vehicles and computers
- Start-up capital
- Instances where the amount of money needed is not going to change.
The term and price of loans will differ between providers and show the risk and cost to the bank offering the loan. For bigger sums, the pricing and terms may be negotiable. Banks will offer loans to businesses based on a significant return for their investment to reflect the risks of defaulting and settle administrative costs.
If you have a good relationship with your bank, they will have developed a proper understanding of your business. This will help them offer you appropriate advice regarding the ideal product for your financial needs.
Different types of bank loans include:
Working capital loans: This type of loan is used for short notice or emergencies
Factoring loans: Factoring loans are loans that are based on money owed to your business by
Fixed asset loans: Fixed loans are used for purchasing assets where the assets themselves are collateral
Hire purchase loans: Hire purchase loans are used for the long-term purchase of assets like vehicles or machinery.
Advantages of Term Loans:
- The loan is not repayable on demand and so available for the duration of the loan (generally three to ten years unless you fail to meet the loan conditions).
- Loans can be linked to the lifetime of the equipment or other assets you are borrowing the money to pay for.
- At the beginning of the loan term, you may be able to negotiate a repayment holiday. This means that you only pay interest for a specific amount of time while repayments on the capital are suspended.
- While you must pay interest on your loan, you don’t have to give the lender a portion of your profits or a share in your company.
- Interest rates may be fixed for the term, so you know the level of repayments throughout the loan.
- There may be a fee (arrangement) paid at the beginning of the loan but not throughout its duration. A yearly renewal fee may be payable if it is an on-demand loan.
Disadvantages of Loans:
- Bigger loans will have certain terms and conditions or agreements that you must stick to, like the provision of quarterly management information.
- Loans are not quite flexible. You could be paying interest on funds you aren’t’ using.
- You could have issues making monthly repayments if your customers fail to pay you immediately, resulting in cash flow issues.
- In some circumstances, loans are secured against the business’s assets or your personal stuff, such as your home, car, etc. The interest rates for secured loans may be lesser than unsecured ones. However, your assets or home could be at risk if you fail to make the repayments when due.
- There may be a charge if you decide to repay the loan before the end of the loan term, especially if the interest rate on the loan is fixed.
When Loans Are Not Suitable?
It is not ideal for taking out a loan for ongoing expenses, as doing so may result in you defaulting on the loan. Rather than fund ongoing expenses with loans from banks, consider funding them with cash gotten from sales, possibly with an overdraft as support.
If you cannot get a loan or other type of finance from your bank, there exist other finance options you can tap from.
The Lending Ability of Commercial Banks Is Increased When:
The lending ability of commercial banks rises when the following happens:
- The Reserve ratio is increased
- Treasury collects tax revenues
- Fed sells securities in the open market
- Fed purchase securities in the open market
- If the Fed purchases government securities from commercial banks in the open market
- The Fed gives the securities to the commercial banks and raises the banks’ lending power.
The Outcome of Increased Lending by Banks:
One of the main functions of a commercial bank is offering loans to the general public. Of course, one can correctly predict what happens when the lending ability of commercial banks decreases. But, what happens when their lending ability rises?
The truth is that if commercial banks increase their lending ability, they’ll get lower rates. But, if they lessen their lending, they have to pay higher interest rates. Because commercial banks find it reasonable and easier to borrow, this persuades them to lend to companies and customers in higher quantities and at reduced rates.
In What Situation a Commercial Bank Will Raise Its Lending?
Reduced interest rates make borrowing affordable. This should raise the demand for bank lending as companies and individuals are encouraged to borrow rather than save. In typical circumstances, a reduction in interest rates might raise bank lending.
Why Do Commercial Banks Lend?
Have you ever sat down and thought about why commercial banks lend? Of course, they lend to make profits off interest. But are there other reasons? You see, commercial banks lend money to individuals and businesses to make a profit. But they also lend money to companies to persuade them to use business checking and savings accounts, financial advisory services, tax preparation services and even investment banking services in a different branch of the bank.
What Increases Bank Lending?
There are a few things that raise bank lending. But, supply and demand seem to top the list. An increase in the amount of money available to borrowers raises the credit supply. For instance, when you open a bank account, you lend money to the bank. The more the banks can lend, the more credit is available to the general public.
What Is the Commercial Lending Process?
Banks don’t just lend people money. There is usually a process. First off, the bank will start a pre-approval process for the business by scrutinizing the financial background and income of the business. Also, the bank will evaluate the existing debt of the business, including the reason for the loan.
Why Would a Commercial Bank Increase Lending?
As we all know, commercial banks are one of the best sources of loans. Businesses and individuals seek loans from commercial banks every day for several reasons. It is normal for a commercial bank to reduce its lending ability, especially in the event of an economic meltdown. But what do you think could make a bank raise its lending?
A commercial bank will increase its lending in the event of an increase in supply and demand. If customers deposit more money in the bank, you expect the bank to lend more and vice versa.
Seeking a loan from a bank is cool, provided you have a plan on how to repay the loan. Ensure you look at other options before requesting a loan from the bank. Also, only seek a loan when necessary, so you don’t incur huge debt, thereby ruining your finances.